Published on November 15th, 2011 | by Luis Cavalcanti

Why the Insider Trade Allegations on Capitol Hill Might be Stupid

It’s interesting to me that in listening to discussions about the stock portfolios of politicians on Capitol Hill, the disdain with which people speak the words insider trading. I’m no banker, I’m not an economist and I don’t purport to be an expert on general market forces. But I refuse to take at face value the belief that insider trading is obviously bad.

The reality is that markets are supposed to be a reflection of fact. The price of a stock ought to reflect the value of a company. What is reflected in that value are both a company’s tangible assets and whatever intangible value that is prescribed to that company based on their general value to society. These can include the value of a company’s brand, intellectual property like patents, or, perhaps, a company’s value might reflect their competitive advantage based on their better-than-average employees.

The reality is, how shares are valued is not simple to calculate. After all, Facebook is worth nearly $50 billion dollars despite having profits of only $700 million or so (although that’s speculative). The reason is that investors believe that Facebook’s profits will eventually be reflected in what looks to the outside world to be a currently inflated valuation.

Why do companies like Goldman Sachs value facebook at nearly 100 times earnings? The answer is simple, within investment there are levels of information. Most of us are on the outer circle of information. We get information from the Wallstreet journal, or from the local nighlty news, or from our guts. Most of us are not exactly within the pantheon of expert investors. We find our way in the markets by either avoiding them altogether, investing in mutual funds or jumping in and taking big risks. Then there are those whose job it is to invest.

Many of these companies will become experts in one particular stock. I knew on girl whose job it was to go around the world visiting Abercrombie & Fitch stores. She would speak with managers, take them out to lunch, and get as much information as she could about each individual store. Then, armed with that information, her company would decide to buy or to sell short the stock. Months ago, when most analysts were bearish on the Abercrombie, her company bought up as much as they could. Months later, based on the information she collected, they made a ton of money when the stock moved in the opposite direction analysts thought it would.

Needless to say, you and I would have been poorly situated to capitalize on Abercrombie’s surprising upward trend. Other investors, like Jim Cramer, are quite a bit more diversified. These investors oftentimes work on tips, they work through prospectuses, they are well versed in understanding and reading balance sheets. They spend their days trying to find companies that are undervalued and throwing money at them. There are yet other investors who work in small cap, low trade volume, so-called penny stocks. In this world, it’s common for investors to have obtained enough shares in one or more companies to be able to manipulate the prices of stocks by strategically buying and selling shares. In the world of penny stocks, the value of a company isn’t even necessarily tied to anything rational. It is oftentimes very speculative and these stocks can see dips and climbs that double the value of the stock overnight. Penny stocks are highly volatile and, while the expected value of penny stocks might be higher than your traditional blue chip, penny stocks come with a relatively high chance of making taking an investor’s shirt.

While there are definitely other classes of investors, I am painting investors with a fairly wide brush for the purposes of simplicity, which brings me to the most important players in a market. While the investors I’ve spoken about so far are all privied to public information, it’s important to understand that public information doesn’t mean that the information is simple to get, nor does it mean that the information is readily available somewhere. For example, the Abercrombie trader gets her information by talking to hundreds of store managers, putting together what they all tell her, and making decisions about the company as a whole. The reason it works is because by asking all the managers of all the stores, or many of the managers at many of the stores, she ends up with what is essentially an analysis of trends that reflect the entire company’s outlook. She develops a dataset that is based on public information that she’s obtained by legal means, and can determine profitability in the next quarter compared to previous datasets that she’s constructed. When her information shows her that the company is going to be more profitable, they buy.

When a company releases their internal information, and the stock goes up as a result of the news being positive, she’s already acted on the news because she has obtained what looks like insider information by collecting data from enough sources that she could act on it. Likewise, other investors who act on tips, are getting information from people like her or people who are close to a source that is knowledgeable about a company. Needless to say, you and I won’t get a call about Abercrombie the next time there is an opportunity to make money there.

You know who else probably had information about Abercrombie’s balance sheet? Their CEO Mike Jeffries probably knew exactly what that quarter looked like. Obviously, right? Well, the thing is, he’s not allowed to invest without a huge amount of paperwork, public disclosure and time. Based on how people have reacted to the 60 minutes story about insider trading being done by your very respectable, honest Congressmen, I imagine that most of you think that Mike Jeffries ought not be allowed to invest in the company without massive amounts of disclosure. But I’m wondering, and I think I might be right, that his inability to invest is a huge disservice to the market. Since markets are a reflection of individuals’ willingness to pay a certain price for a stock, the willingness of a company insider, is, in general, going to be a far better reflection of a company’s overall value, which is the point of stocks.

And when it comes down to it, most insider information can be obtained by putting in the legwork. But what about the Enrons or WorldComs? Well, the reality is that we need to diversify as investors. But if you had known about the woes of the two companies, would you not have exited the market?

The reality of investing is that it should be an inherently reasonable act. Every single person should invest based on the information that is available to them. IF you want to be a sophisticated investor, you can go talk to all of the managers of whatever your investing in. If you don’t, you can let someone else do the legwork, and you can put your money in a hands off mutual fund. If investing is about making rational decisions based on information each of us have, then shouldn’t insiders also be able to act on what they know about a company? Isn’t the invisible hand of the market supposed to be a reflection of the aggregate sentiments of all potential investors? If that is the case, than how can we leave the most knowledgeable investors out of that equation? It seems to me that asking people to not act on information that they have obtained is far worse for a market than people acting on information they have that might not be immediately available to the public.

That said, the other side of this coin is that people respond to incentives. My operating premise here is Milton Friedman’s belief that a company’s executors most important moral obligation is toward company profits. One critique of such insider trading might focus on these incentives. In a world of complex derivatives and short sales, one might point out that a less than scrupulous executive might be incentivized to destroy a company in order that a short sale pays off. But the reality is, very few people have ever made it super wealthy by shorting the market. A majority of the time, it is the veil of secrecy behind which companies operate that can cause successful shorting opportunities for external investors.

I remember once reading an analysis regarding market incentives. It was pro-shorting without restrictions argument that the ability to make money as a result of a company’s demise is the best incentive to keep companies honest. There are numerous examples of individuals who have caught companies in the midst of fraud. Oftentimes these investors will sell short a company’s stock before going public with their findings. If that is a real possibility, and these incentives are problematic, then I’ve proved my non-expertise. But, if as I suspect, this problem is mitigated by market forces and the fact that it is likely that a succesful, fast growing company’s yields will be far better than destroying that company, the next question I have is why do we punish people for having too much information. In some ways, I wonder if this is the adult version of handicapping kids who are too good at sports – making a kid who scores too many touchdowns sit on the sidelines.

Ultimately, I’m not going to render a strong opinion on insider trading. I will put out there that it was Joe Kennedy who relaly plugged the legal holes that allowed people to engage in the practice. That said, insider trading is how Joe Kennedy made all his money. Since then, a terrible stigma has become attached to the practice. And while I’m not sure if I’m correct, I am sure that at the very least, not allowing the most informed stock buyer from participating in the market HAS to have incredible consequences of which we are not even aware.