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Thursday, October 7, 2010

Is it a good idea to buy or sell shares on insider information?

Before attempting to answer the question, it may be a good idea to define what ‘insider information’ means:

Material information about a company that has not yet been released to the general public, but is known to the company’s board of directors, executive management, employees, consultants.’ 

‘Material information’ means information that can affect the price of a company’s stock – like M&A activities, rights/bonus/stock-split, fund raising, changes in top management, new product launches.

Usually, such material information is formally sent to the stock exchanges before announcing it in public through TV interviews or press conferences. Often, reporters of newspapers or business channels get wind of such information through their sources, and quiz management about it. And managements deny any such plans.

Some times, managements are not available to confirm or deny and the newspaper/TV channel goes ahead and releases the ‘news’. The company then denies the ‘news’ or says ‘no comments’. More often than not, the ‘material information’ is later made public by the company after a few days.

There is a good reason for this play-acting. It is illegal for any one to trade the shares of a company based on insider information. For that reason alone, it isn’t a good idea to buy or sell shares if you have insider information.

Taking or giving bribes is also illegal. But people do it anyway, because it has become the unwritten practice of doing business in India. So why not trade on insider information? What if you trade using your brother-in-law’s demat account? How will you ever get caught?

Using dubious methods to bypass the law doesn’t make the activity legal. But there are logical and better reasons for not indulging in insider trading. And the reasons are simple.

Unless you happen to be the managing director or finance director or a senior consultant of a publicly-listed company, the ‘insider information’ will come to you second-hand or third-hand. That means, those who had first-hand information would have already traded on the basis of the information. And the stock price would be reflecting their transactions.

What if the ‘insiders’ are upright and honest and did not trade on the basis of the material information? Wouldn’t that give you an advantage over the general public? Well, if the ‘insiders’ were really honest, they wouldn’t go around leaking insider information, would they?

A more important reason is the quality and financial strength of the company. Most ‘insider information’ being made selectively available to small investors are invariably about third and fourth rate companies. You will almost never get any insider information about L&T or ITC or Tata Steel. It will always be about little-known small-caps or companies that have seen better days.

A reader recently emailed me with a query about a PSU whose glory days have been left far behind. I responded that the company is trying to come out of the woods, but the technical chart looks very bearish. The reader then revealed that he had some ‘inside information’ that could lead to a sharp spike in the stock price!

Insider information and hot stock tips tend to fly around when the stock market is near a top (like now). Smart investors should use such information to sell, only if they happen to hold such stocks.

That was the long answer. The short answer is: No.

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