CAMBRIDGE, Mass., Jan. 12, 2003 — Even as Martha Stewart faces trial for allegedly violating insider trading rules, an MIT Sloan finance professor says individual investors should pay closer attention to the perfectly legal, if troublesome, insider trading decisions made by managers of companies in which they own stock.
“Managers obviously don't think the market is perfect,” explained MIT Sloan Prof. Dirk Jenter. “They see very high valuations as excessively optimistic and very low valuations as excessively pessimistic. Given that they probably know quite a few things more about their companies, if managers don't believe the extremes of the market but actively go against them in their private trading decisions, maybe I as an individual investor should not believe the market either. If a CFO seems to be contrarian, then I should probably be one too.”
Jenter's analysis of insider investment decisions by managers finds that managers actively time the market both in their private trades and in firm-wide decisions. “My results on insider trading suggest that managers' views on valuations diverge in a systematic fashion from market valuations,” he said. “They are closer to the average than the markets.
This would seem to make sense since managers “are indeed supposed to know the most about their company,” said Jenter. What makes less sense, he said, is that the broader market, and stock purchasers in general, often fail to pay proper heed to such insider decisions. Information about stock decisions by insiders is available if an investor knows how to find it. “Clever investors are able to figure this all out,” said Jenter. “In a way, what we are seeing is discrimination against the uninformed.”
Jenter stressed that managers are not using particular inside information or other data that would violate insider trading laws. Rather, they are using insights into their own companies to determine that the market is giving them values that are too low or too high. When too low, the managers buy shares; when the market valuation is too high, they sold.
While perfectly legal, such decisions by managers to buy or sell shares in their own companies when they feel market valuations are too high or too low pose a predicament for corporate executives.
“It creates a dilemma when the manager disagrees with the market,” said Jenter. “A manager may fully believe that a market valuation is quite wrong, but the average CEO could risk a potential lawsuit (by shareholders) by going public and saying the stock is overvalued, especially if the share price ultimately drops. On the other hand, if managers don't make their personal beliefs know, you can end up in an Enron-type situation.”
Such contrarian investing is nothing new, Jenter noted. Warren Buffett, for example, has made fortunes by refusing to believe in the high highs or in the low lows of the market. What does surprise Jenter is “how systematic” contrarian investing has become among managers. “The disagreement between managers and markets isn't just sporadic, but consistent at the extremes,” he said.
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