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This paper documents that insiders are both contrarians and possessors of superior information. We find that insider trades are positively related to the firm's future earnings performance (proxy for superior cash flow information), positively related to the firm's book-to-market ratio and inversely related to recent returns (proxies for trading against misvaluation). Each relation has incremental explanatory power, yet information about future cash flow changes explains a smaller portion of insider purchases than do proxies for security misvaluation. The relation between insider trades and future earnings performance is amplified (attenuated) as the benefits (costs) to trading on financial performance information increase.

This paper documents that insider trades reflect both contrarian beliefs and superior information about future cash flow realizations. Prior research shows that insider trading activity generates abnormal returns (Jaffe, 1974; Givoly and Palmon, 1985; Seyhun, 1986; Rozeff and Zaman, 1988). Insiders can earn excess profit by either recognizing pricing errors made by outsiders or by having superior knowledge about future cash flow realizations. In the former case, insiders trade against current investor sentiment, recognizing that outsiders make valuation errors through the application of inferior valuation models and/or the incorporation of biased judgements. In the latter case, managers have private information about the pattern of future cash flows. Because prices respond to unexpected changes in cash flow, insiders trade when their private knowledge of future performance and payoffs differs from current market expectations. In both settings, insider trades help push prices towards fundamental value. Prior research supports the hypothesis that insiders are contrarian traders. Seyhun (1992) shows that insiders are more likely to sell (purchase) shares following periods of significant price appreciation (declines), consistent with insiders trading in anticipation of subsequent price reversals. Rozeff and Zaman (1998) show that insiders predominantly buy (sell) shares in value (glamour) firms and interpret this as evidence of insiders trading against the market's over-reaction to past performance. Such trading behavior is consistent with insiders purchasing (selling) securities with high (low) expected returns or the greatest amount of undervaluation (overvaluation) (e.g., Fama and French, 1992; Lakonishok et al., 1994). Past research, however, does not disentangle the source of insiders’ superior trading performance. Rozeff and Zaman (1998)'s pattern of trading across book-to-market portfolios could reflect insiders trading on market pricing errors (e.g., over-reaction to past performance), but it could also reflect insiders’ superior knowledge of future earnings performance. For example, LaPorta et al. (1997) show that, on average, value (growth) firms tend to have positive (negative) future earnings announcement period returns. Because earnings announcement returns tend to be correlated with actual changes in performance, Rozeff and Zaman's findings do not differentiate trading on the basis of contrarian beliefs from trading on the basis of superior information about future cash flows. Prior research has also examined whether insiders trade on the basis of superior future cash flow information. The strongest evidence is found in Ke et al. (2003); they examine insider-trading patterns in advance of a break in quarterly earnings increases and find insider sales increase three to nine quarters before the earnings break. The authors conclude that insiders trade ahead of earnings breaks, but do so several quarters ahead of the break in order to avoid the appearance of trading on near-term, material news about earnings. Similarly, Elliot et al. (1984) find evidence that insiders increase (decrease) purchases (sales) in the 12 months before extreme earnings increases. However, the paper finds little evidence that insiders sell in advance of extreme earnings decreases, dividend changes or bond rating changes. In contrast, studies focusing on insider trading around short-window information events produce mixed results. For example, Givoly and Palmon (1985) are unable to document a link between insider trading profits and subsequent disclosure events (including earnings and dividend announcements), while Noe (1999) examines insider trading around management forecasts of earnings and finds the trading patterns to be unrelated to the forecasted earnings news.1 Our paper extends prior research in two ways. First, prior research does not disentangle two potential sources of insider trading and profits, namely, trading against current investor sentiment (i.e., by trading with less bias and/or better models than outside investors) and trading on the basis of superior cash flow information. Building on the methodology of Rozeff and Zaman (1998), our tests are designed to document whether incremental associations between insider trades and various proxies for contrarian beliefs and future cash flow news exist, and provide evidence on the relative explanatory strength of each set of variables. Second, our research design incorporates all trading activity, not just trading around information events or extreme earnings innovations. Our sample consists of a broad set of ordinary performance innovations that are less likely to attract regulatory scrutiny than extreme performance changes (see Ke et al., 2003). The use of a long measurement window increases the odds that our sample captures both the performance signals being used by the insiders and the transactions themselves.2 Moreover, the long-window research design allows us to use simple proxies for unexpected earnings information at the time of the trade, increasing the power of the tests to detect the hypothesized relations. Consistent with Rozeff and Zaman (1998), we measure investor sentiment/contrarian beliefs using two variables: the firm's book-to-market ratio and recent returns. To operationalize the insider's information advantage about future cash flows, we measure three firm-specific performance variables: next fiscal year's annual market-adjusted stock return, next fiscal year's annual earnings innovation and the contemporaneous annual earnings innovation. In our tests, we assume that these annual innovations represent unbiased (albeit inefficient) proxies of future cash-flow changes that are unexpected by market participants, yet known by management, at the time of the insider's trade.3 If insiders trade on the basis of this informational advantage, we expect to observe greater purchasing (selling) behavior in advance of unexpectedly strong (weak) performance, ceteris paribus. To the extent that these proxies do not fairly represent the insider's private knowledge about unexpected performance innovations at the time of the trade, this measurement error will reduce our ability to document a relation between insider trading and future firm performance. Establishing incremental relations among insider trading, future cash flow news and proxies for contrarian beliefs is relevant for several reasons. First, we can establish that insider trading against misvaluation (i.e., on the basis of contrarian beliefs) and with superior information represent distinct trading scenarios. After controlling for future cash flow news, trading associated with book-to-market ratios and past returns is likely to reflect misvaluation and investor sentiment rather than correlated future performance changes. Similarly, an incremental relation between future cash flow news and insider trading would confirm that the results in Ke et al. (2003) are distinct from investor sentiment/misvaluation. Second, from a valuation perspective, a significant relation between insider trading and future firm performance would suggest that insider transactions are legitimate signals about future cash flows that can be used to improve earnings forecasts and equity valuations; such a signalling role would be consistent with Manne (1966a) and Manne (1966b) and Carlton and Fischel (1983), who argue that insider-trading benefits society by inserting insiders’ information into prices. Thus, our results are relevant to the on-going debate over the effect of insider trading on market efficiency. The rest of the paper is organized as follows. Section 2 discusses our research design, methodology and the data, while Section 3 presents the main findings. Section 4 extends the main findings and Section 5 discusses robustness tests. Section 6 examines the insider's decision to trade, while Section 7 concludes.

Existing research has separately shown that insiders trade on the basis of contrarian beliefs (e.g., Rozeff and Zaman, 1998) and on the basis of superior knowledge about future cash flow news (e.g., Ke et al., 2003). This paper examines whether these two insider-trading activities are incremental to each other and assesses the relative magnitude of these relations. We utilize a research design that measures current trading activity, proxies for contrarian beliefs and future earnings performance at the annual level. We find strong evidence that insider purchases are positively related to future earnings performance, positively related to book-to-market ratios and inversely related to past returns. Each of these relations has incremental explanatory power for insider purchases, suggesting that insiders trade on the basis of both contrarian beliefs and private information about future cash flow news. These superior information results are robust to several measures of insider-trading behavior and future earnings performance and are consistent with Ke et al. (2003), who document a relation between insider trades and future earnings downturns. Finally, in terms of relative importance, superior information about future cash-flow changes explains a smaller portion of insider purchase activities than do proxies for security misvaluation. While our paper does not examine the profitability of insider trades, we do investigate the relation between insider trading and future earnings conditional on the expected benefits and costs associated with trading on performance-related information. Specifically, we examine insider-trading behavior conditional on cross-sectional differences in information environments, inter-temporal differences in insider trading enforcement regimes and intra-firm differences in the access to information. We find that relations between insider purchases and current and future earnings performance strengthen in weak information environments (i.e., small and thinly followed firms). We find that, in response to new legislation expanding the enforcement of insider-trading laws, the relation between insider-trading and earnings performance shifted from current to future earnings news. This shift is consistent with insiders basing their trades on a less blatant form of informational advantage in the stronger enforcement regime. Finally, the relation between insider purchases and earnings news is marginally stronger for executives than directors, consistent with an executive's more timely access to performance-related information. We also find that insider-trading behavior within book-to-market portfolios varies by the horizon of the subsequent earnings news. Although insider purchases are significantly positively related to next year's earnings performance across all BM partitions, the sign of the relation between insider purchase activity and contemporaneous earnings innovations depends on the firm's BM classification. Given good current earnings news, insiders at glamour firms sell, while insiders at value firms buy. This shift from selling to purchasing behavior is nearly monotonic across BM portfolios. The recognition that insiders trade as contrarians and as possessors of superior information has several implications. First, trading on the basis of security misvaluation implies that insiders frequently act like arbitrageurs, exploiting valuation errors arising from outsiders’ inferior valuation models and/or biased judgements. Second, insider purchases convey information about future earnings, and investors should treat these trades as credible signals when forming earnings forecasts and equity valuations. This predictive ability should be strongest where the relation between insider trades and superior knowledge was the strongest, namely, among the small, thinly covered firms. Together, these implications suggest that insider trades will help push prices towards fundamental value.