The Information Content of Insider Trading: Evidence from Stock Splits

Transcription

1 The Information Content of Insider Trading: Evidence from Stock Splits Xu Sun * University of Texas Pan American Thanh Ngo East Carolina University Surendranath Jory University of Sussex * Contact Author: Xu Sun. University of Texas Pan American, 1201 W University Drive Edinburg, TX xnsun@utpa.edu

2 Abstract This study reexamines the controversy on the motivations of insider trading in a special context stock splits. Since stock splits are documented to be associated with price appreciations, insiders will tend to sell holdings before stock splits if they are contrarian investors. If, they possess positive information of corporate future cash flows before split announcements, they will reduce their sales or even increase their holdings. The results provide evidence that insiders act as both contrarian investors and superior information-holders. Insider selling behavior dominates purchases before stock splits. Ina addition, the net insider purchase is higher for firms with better operating performance in post-split periods. Keywords: Insider trading; Stock Splits;

3 I. Introduction Previous studies on insider trading show that insiders are able to generate positive abnormal returns from their trading activities (Givoly & Palmon, 1985; Jaffe, 1974; Rozeff & Zaman, 1998; H. Nejat Seyhun, 1986). Studies believe that insiders are capable of earning abnormal returns because either they are contrarian investors, or they are superior information holders, or both. On the one hand, insiders, as contrarian investors, trade against the market, holding that outsiders make biased judgment on stock valuation. Insiders hence trade in the opposite direction with current market to correct any valuation errors (Jenter, 2005; Rozeff & Zaman, 1998; H Nejat Seyhun, 1992). On the other hand, insiders have private access to corporate information on future cash flows ahead of the public, and thus are able to earn excess returns if they trade on their private information (Jiang & Zaman, 2010; Ke, Huddart, & Petroni, 2003; Penman, 1982; Pettit & Venkatesh, 1995). Studies like Pettit and Venkatesh (1995) and Piotroski and Roulstone (2005) provide evidence for both insiders contrarian beliefs and future superior information. One way to test for whether insiders trade on their private information on firm prospects is to examine insiders trading patterns before major corporate events. John and Lang (1991) document a significant positive relation between insider selling and negative excess returns prior to dividend announcements. Gombola, Lee, and Liu (1999) and Clarke, Dunbar, and Kahle (2001) both show increasing insider selling prior to new issue announcements, and document that pre-issuing insider selling is related to post-issuing firm growth and long-run performance, respectively. Bonaimé and Ryngaert (2013) show an increase in insider trades before share repurchases, with insiders selling more than buying. They also show that repurchases associated with insider buying are followed by higher excess returns than those with insider selling, partly supporting the superior information possessed by insiders. Among the many corporate events, stock split is quite unique. This particular event, unlike dividend initiations, merger and acquisitions or other events, appears to have little or no impact on firm assets, capital structures, cash flows, or taxes. The primary reasons for conducting stock splits as suggested in prior studies might include (i) achieving a preferred and acceptable share price, (ii) widening the range of share distributions, and (iii) facilitating trading stock liquidity on the secondary market. In the literature, the effect of split announcement on 3

4 share prices has been studied for many years. Past studies have consistently found significant abnormal returns around stock split announcement (Desai & Jain, 1997; Fama, Fisher, Jensen, & Roll, 1969; Ikenberry & Ramnath, 2002; Ikenberry, Rankine, & Stice, 1996; Lamoureux & Poon, 1987; Reilly & Drzycimski, 1981). The positive effect cannot be considered simply as market overreaction as Ikenberry and Ramnath (2002) document that the 9% positive return drift can last for nearly one year. However, there is no consensus on the causes of such price run-ups. Stock splits are mostly documented as being associated with share price appreciation around the split announcements. If insiders trade in the contrarian way as suggested by previous studies, then the insider selling trades are expected to dominate purchasing behaviors before corporate split announcements. Ma, Sun, and Yur-Austin (2000) provide supportive evidence for increasing insider selling prior to stock splits, but they fail to examine whether abnormal insider trades before stock splits are motivated by insiders private information in the future. In this study, I attempt to fill the void in the existing literature on insider trading activities prior to stock split announcements in the following several ways. First, I reexamine insiders trading patterns before stock splits. I hypothesize that insiders, being contrarian investors who believe current market prices are plagued with errors and trade in the opposite market sentiment, tend to sell their shares before stock splits. The counter argument is that insiders possess private information about the firms and would buy more of the firm shares in anticipation of future higher stock price of the firm. Second, I extend prior researches by disentangling the motivations behind insiders trades before stock splits. If insiders base their transactions on future cash flows, then I expect to see an incremental effect of future performances on pre-split insiders trades, above the explanatory power of contrarian effects. Pettit and Venkatesh (1995) and Piotroski and Roulstone (2005) show that insiders trade on both their contrarian beliefs and their private information of corporate prospects. If insiders are optimistic about firm futures, then they will reduce their sales or increase their purchase before stock splits. The second hypothesis hence is, insiders of firms with better future cash flows buy more of their firm shares than those of firms with worse future performance. 4

5 The rest of this study is structured as follows. Section II reviews previous studies on insider trades, stock splits, and firm performances around stock splits. Section III and IV describe the data sources and the methodology adopted in this study. Section V presents empirical results, and Section VI provides several robustness checks. Section VII summarizes the major findings and concludes the paper with implications. II. Literature Review Previous studies pose two dominant views regarding to the motivation for insider trades. The first one states that insiders are able to detect mispricing of their securities based on their information. Hence, they tend to act as contrarian investors by going counter with the market sentiment and making profits from market pricing errors. For example, Rozeff and Zaman (1998) find increasing insider purchases after low stock returns and decreasing insider purchases after high stock returns. Jenter (2005) provides further evidence by showing that top managers of low valuation firms consider their firm as being undervalued and trade and make corporate decisions on their perceived mispricing of firms. Managers of value firms are more likely to buy more of the firm shares while managers of growth firms tend to sell more of their firm shares. This mispricing hypothesis hence implies that insider trading is associated with market overreaction/under-reaction, which will profit insiders from subsequent market correction, and such insider trades do not contain any information specifically related to firm prospects. The second view suggests that insiders are more informed about the firms than the public, and holds that insiders trade on their private information on future cash flows of their firms. As such, insider trading patterns can be used to predict firm future performance and stock returns. Jiang and Zaman (2010) decompose the market returns and find supportive evidence that insiders trade is strongly correlated to unanticipated news on future cash flows. This evidence suggests that insiders possess private information on firm future performance and they trade based on their anticipations on their firms rather than perceived mispricing. Some studies, however, find evidence for both contrarian hypothesis and information advantage hypothesis. For example, Piotroski and Roulstone (2005) document that insider trading activities are positively related to firm s future earnings performance and also negatively related to contemporary returns. 5

6 According to the signaling hypothesis, if insiders have superior information about the company prospects over other market participants, then they may be motivated to trade on their information, especially prior to major corporate events. Examining the insider trading activities prior to seasoned equity offering announcements, Gombola et al. (1999) argue that firms with great growth opportunities are more overvalued than mature firms, and hence corporate insiders of growth firms tend to sell their holdings prior to SEO announcements so as to take advantage of market optimism. However, they do not find supportive evidence for the rational expectation hypothesis of insider trading before SEO announcement; insiders from growth firm will hold, rather than sell, their stakes if they incorporate company future growth information in their trading patterns prior to SEO announcement. Clarke et al. (2001) provide strong evidence for insiders opportunity trading before SEO announcement. Specifically, they find that pre-filing insider selling behavior increases before both completed and cancelled SEOs, and is related to post-offering stock performance for completed SEOs and to stock performance before SEO cancellation. Studies such as Bonaimé and Ryngaert (2013), John and Lang (1991), and Bonaimé and Ryngaert (2013) have documented an increase in insider trading activities around dividend announcement, stock repurchase announcement, and new equity issue announcement. While, some other studies fail to find significant evidence for insiders trading prior corporate events. For example, Lee (1997) finds no significant difference on the post-seo firm performances between firms with pure insider selling and firms with pure insider buying. Stock split are suggested by past studies as a way for companies to signal positive information to public investors. Some studies attribute the significant price run-ups in the postsplit periods to increasing information flow between informed and uninformed investors, and to positive market reactions to the stock split signals. For example, Brennan and Hughes (1991) argue that firms conduct stock splits to promote their shares by raising attention of analysts and investors. Conroy and Harris (1999) support the signaling hypothesis of stock splits by showing that market and analysts earnings forecast react positively when the announced split factor is larger than expected and leads to a lower price than the expected post-split price. Chen, Nguyen, and Singal (2011) find that institutional investors are better than individual investors in assessing information contained in stock splits, and document that splitting firms with greatest changes in institutional ownership show significantly positive growth in both stock returns and earnings in the year immediately following the split event. 6

7 Unlike stock prices and returns, which could be driven by investors information and transaction costs, corporate earnings reflects the profitability and hence the true value of a firm. Companies could also choose stock splits as a means to convey their optimism about future earnings to the market. As market gradually revises its expectations of splitting firms upward based on the future fundamental value, the share prices tend to appreciate accordingly. Lakonishok and Lev (1987) state that the splitting firms enjoy high earnings growth both before and after splits. Ikenberry and Ramnath (2002) and Chen et al. (2011), matching splitting firm and non-splitting firms based on certain firm characteristics, also support that the former tends to gain high earnings growth and is less likely to experience earnings declines in the post-split period. Thus, Chen et al. (2011) conclude that stock splits reflect information on future firm growth, rather than past growth. Since stock splits are mostly characterized by increasing post-announcement performance, following the superior information hypothesis of insider trading studies, insiders may react abnormally before split announcements as well. As suggested in the signaling hypothesis, insider trading behaviors are related to subsequent stock returns and operating performance of firms. For example, Beneish and Vargus (2002) suggest that previous persistent income-increasing accruals is significantly lower for insider selling and significantly higher for insider buying, indicating informed insiders trading on earning quality. Also, Piotroski and Roulstone (2005) show that insider trading is significantly related to firm s future earnings performance, as measured by changes in return on asset (ROA) and abnormal buy-and-hold returns of sample firms in the following year. However, studies regarding to insider trading around stock splits announcements are inconclusive. Devos, Elliott, and Warr (2014) find that CEOs tend to behave opportunistically around stock splits. Specifically, they report that CEOs are able to achieve $322,960 ($125,664) on average through additional buying before the split announcement and additional selling in the post-split period. Ma et al. (2000) argue that insiders before stock splits announcements by showing that insiders tend to sell, rather than purchase, prior to announcements, and they conclude that insiders trade for portfolio balancing purpose instead of superior information. 7

8 III. Data Insider trading data is obtained from Thomson Financial Insider Filing Data Files, which report corporate insider trades reported to SEC on forms 3, 4, and 5. The definition of insiders by SEC includes directors, officers, and major stockholders holding more than 10 percent of shares of the total numbers of shares outstanding of a particular firm. Previous studies like H. Nejat Seyhun (1986) indicate that trades by outside principal shareholders do not convey much information. In this study, I exclude the third type of insiders and focus on only the managerial type of insiders who are directors and officers. These insiders include Chief Executive Officer (CEO), Chief Financial Officer (CFO), Chief Operating Officer (CO), officers, and chairman of the board, directors, president, and vice-president 2, who are assumed to have direct access to corporate information on firm prospects. Before, Section 16(a) of the Securities Exchange Act of 1934 requires that all open market trades by corporate insiders be reported to SEC within 10 days after the end of trading month. Sarbanes-Oxley Act of 2002 reduces the reporting time to two business days following transaction. Following previous studies on insider trading, I further apply several filtering criteria to the sample as described below: Insider transactions should only include open market and private purchases (transaction code P ) and sales (transaction code S ) on common or ordinary shares. Stock transactions are not related to exercise of options ( option sell indicator = N ). Following H. Nejat Seyhun (1986) and Clarke et al. (2001), transactions that are duplicate, amended ( amend If the filing represents an amendment to an earlier filing, an A will appear in this field. Otherwise, the field will be left blank), inconsistent, and have fewer than 100 shares ( shares number of shares), are deleted. All trades must have corresponding transaction dates and filing dates to identify the date the trade occurred and the date the trade was publicly disclosed. Financials (Sector 01) and utilities (Sector 11) are removed, as these firms are in highly regulated industries and tend to have unreliable repurchase data. 2 The selection of insiders focuses on corporate management with role codes of CEO, CFO, CO, O, OD, CB, D, P. VP. 8

9 After applying these criteria, the insider trading sample contains 1,502,887 transactions by individual insiders from year 1986 to Then all insider buying and selling transactions within a single firm are aggregated on a monthly base to get the monthly total insider purchases and sales for each firm over time. After this step, the sample has 226,707 monthly observations from 12,065 firms left. The stock split events are obtained from the Center for Research in Security Prices (CRSP) Tapes and are those conducted on common stocks only (CRSP code of either 10 or 11). To be included in the sample, the splitting firms must satisfy the following criteria: The split stock must have stock trading from CRSP tape and quarterly accounting information from COMPUSTAT as least 4 quarters after split event, and insider trading information at least on the splitting month. The security cannot be Real Estate Investment Trusts (REITs), American Depository Receipts (ADRs), or close-end mutual funds; The price of the splitting security must exceed $1 to eliminate noising trades; Following Ikenberry and Ramnath (2002), Byun and Rozeff (2003), and Chen et al. (2011), split events must have a split factor equal to or greater than 0.25 to eliminate the effect of certain split ratios on post-split returns 3. Firms cannot have more than 1 stock split event within 300 days. After merged the split sample with the insider sample, COMPUSTAT data, and CRSP data, the final split sample contains 2,279 split event from year 1991 to Table 1 presents the final sample frequency distribution by different criteria. As shown in Panel A of Table 1, the number of split events has dropped in recent decades. Panel B shows that the common 2-to-1 stock splits with a split factor of 1 accounts for 55.85% of the whole sample, which is slightly higher than 45% reported in Chen et al. (2011). Panel C of Table 1 shows the breakdown of the sample by industries based on Fama and French 12-industry classification. 3 As suggested in Grinblatt, Masulis, and Titman (1984), a stock split with split factor smaller than 0.25 is classified as a stock dividend. 4 Year 1986, 1987, 1988, 1989, and 1990 have observations less than 3 so observations in these years are excluded from this study. 9

10 After excluding financial and utilities firms, the sample does not contain extremely skewed distributions in certain industries. 4.1 Matching Splitting Firms IV. Methodology I estimate the abnormal performance of splitting firms using a matching methodology similar to Ikenberry and Ramnath (2002) and Chen et al. (2011) that matches each splitting firm with a non-split firm based on firm size, value/growth, and momentum. To identify the control firm, I form a matching pool of 125 portfolios. First, based on the market value, defined as the market capitalization, of each firm at the end of the month prior to the split announcement, five quintiles of all public trading firms, including splitting firms, are formed using NYSE capitalization breakpoints for a given month. Then, within each market capitalization quintile, I further create five return quintiles based on each firm s prior 36-month return. In the last step, each of the past return quintiles is further divided into five groups based on each firm s returns during the past 12 months. This procedure generates a total of 125 portfolios based on size, value and momentum, respectively. Within each portfolio, all firms that do not split their stocks but have the same ranks in size, value and momentum with the target split sample become matching candidates. Ikenberry and Ramnath (2002) point out that this matching procedure helps to avoid the momentum effect and past value effect on post-split performance. For each split firm, a value-weighted and an equally-weighted portfolio are formed. The stock performance and financial performance of each split target are then adjusted to the performances of the value-weighted and an equally-weighted portfolio, respectively. Table 2 reports the descriptive statistics of firm characteristics for 2016 splitting firms, their value-weighted portfolio, and their equally weighted portfolio formed based on size, value and momentum. The firm characteristics include the natural logarithm of market value (MktCap), capital expenditure scaled by total sales (CapExp), market value to book value ratio (MtoB), research and development expenditure scaled by total sales (RD), long term debt scaled by book assets (Leverage), natural log value of shares traded (Liquidity), and the total property, plant and equipment costs scaled by total sales (PPE) of splitting firm i at splitting announcement 10

11 month. The average (median) market value is $ ( ) millions for splitting firms, $ (53.313) for the value-weighted portfolio, and $ ( ) millions for the equally weighted portfolios. In addition, splitting sample has an average return of 5.8% (3.9%) in 12 (36) months prior to splitting announcements, which is slightly lower than the 6.4% (4.2%) for the value-weighted matching portfolio, and 6.0% (4.0%) for the equally weighted matching portfolio. As to operating performance as measured by operating cash flow (OCF) and return in assets (ROA), splitting sample has better performance than the matched portfolios. The mean OCF (ROA) of splitting firms is 2.5% (2.5%), which is slightly higher than 1.8% (1.8%) for the value-weighted matching portfolio, and 2.1% (1.1%) for the equally weighted matching portfolio. Overall, splitting firms have similar firm-level characteristics with matching portfolios. 4.2 Performance around Stock Splits Stock Performance As a preliminary test, I first re-examine the performances of splitting stocks, as compared to their value- and equally- matched portfolios. To be consistent with previous studies, the announcement period is defined as the three windows around the announcement day, from day -1 to day 1, with day 0 being the announcement day (Day -1 to Day 1). Abnormal performances are measured by stock performance and by financial performance, respectively. Following Ikenberry and Ramnath (2002) and Chen et al. (2011), the abnormal stock performance, which is the N-day/month holding period return for a splitting firm i, is calculated as the difference between the holding period return of firm i and the holding period return of a value- or equallymatched portfolio m over N periods Operating Performance 11

12 If split announcement contains information about future prospects and insiders are able to access and use this kind of information better than others, then insider trading patterns before split announcements are expected to be associated with post-split performance of splitting firms. Unlike stock performance, operating performance of a firm will not be affected by the market price pressure caused by insider buying or selling and might be better proxies for subsequent performance of split firms. In this study, the post-split operating performances of split firms are measured by operating cash flow, which is the operating income before Depreciation and Nonrecurring items (OIBDP) deflated by market value of assets (Carline, Linn, & Yadav, 2009), and return on asset (ROA), which is defined as the net income divided by total assets. As argued by Chen et al. (2011), the public annual accounting data are subject to postsplit earnings information leakage around split announcement, and one way to avoid this issue is to construct annual earnings from quarterly earnings data. So in this study, the operating performance within year t is defined as the average of quarterly performances during 4 t quarters immediately following the stock split announcement quarter, and so on. where is the annual and is the quarterly operating performances, as measured by operating cash flow or ROA for year T(T=1, 2, 3; q=1, 2,, 12). The abnormal earnings growth of a split firm i hence is measured as the difference in the earnings measure of the firm and that of its matching portfolio,, in the same period. 4.3 Insider Trading {Ke, 2003 #78@@author-year} document that insiders start to trade as early as two years ago prior to accounting disclosure in order to avoid legal penalty. So, following Gombola et al. (1999) and Ma et al. (2000), the announcement period is expanded to the 36 months before stock split announcements, centered at the announcement month. Three measures for insider trading activities are the number of shares traded by insiders, the dollar value of trades by insiders, and the number of transactions by insiders. Gombola et al. (1999) discuss the three measures as 12

13 reflecting the depth of insider trading, the price information of insider trading and the breadth of insider trading, respectively. Following previous studies (Clarke et al., 2001; Jiang & Zaman, 2010), the net purchase ratio of insiders in firm i for month t is calculated as where and stand for the purchases and sales of company insiders in firm i at month t, respectively. and are derived as the sum of purchasing and selling transactions of all individual insider transactions within a particular month t, respectively. Table 3 reports the sample distribution for insider purchase ratios as calculated based on number of shares traded by insiders, the dollar value of trades by insiders, and the number of transactions by insiders before stock splits. On average, insider sale dominates insider purchases prior to splits. A net purchase ratio of -1 (1) then indicate that no insider purchase (sale) during a specific month. The average net purchase ratios using three measures during three months prior to splitting month are -24.7%, %, and -23.8%, respectively, and the ratios grow large if larger period is used. Figure 1 plots the monthly insider buying, selling, and net buying 36 months before stock splits. In general, there are more insider selling than buying each of the 36 months before 5. Moving from further month to closer month to the split month, there is not much variations in insider buying but insider selling grows sharply, which results in a significant drop in net purchase ratio prior to split announcement month. This increase in net selling is consistent across all three insider trading measures. It is noticeable that the changes in insider net buying start as earlier as 24 month before split announcement days. 4.4 Insider Trading and Operating Performance To test the hypothesis of whether insiders trade on their information about future firm financial performance before stock split announcements, I regress pre-split insider net purchase ratio among split firms on firm post-split abnormal operating performances and post-split abnormal returns while controlling for other firm characteristics. If insiders behave in a contrarian way before splits, insider selling should dominate insider buying before splits among 5 However, this trend may be biased as Thomson Financial Insider has more selling transactions than buying transactions. 13

14 firms with better post-split performance as opposed to firms with worse post-split performance. In other words, there is a negative relationship between net purchase and the firm post-split performance. At the same time, if insiders trade on their superior information ahead of the public before stock splits, they would buy more of their firm shares prior to the split if they project better post-split performance of their firm. Thus, there is a positive relationship between net purchase and the firm post-split performance. Where stand for the net purchase on split stocks over n months prior to split announcements for stock i. Given different periods, -n can take the value of -36, -24, -12, -6, or -3 for average insider purchase ratios over these period prior to splits. is the monthly net purchase ratio prior to split announcements for stock i, and n can be -3, -2, -1, or 0 for the event month. is the average 12-month abnormal return after split announcement over N months and N can take the value of 12, 24 or 36. is a vector of 4 dummy variables denoting the ranks of the abnormal operating performances of split target T years after the split quarter (T = 1, 2 or 3). This variable can be either operating cash flow (OCF) or Return on assets (ROA)., is the raw operating performance measure and is used to test for the relation between insider trading and post operating performances. stands for the announced split factor of stock i. and are the 36-month and 12-month average stock return for stock i prior to split announcement at split month t, respectively. is a vector of firm characteristic variables of stock i 6, including the natural logarithm of market value (MktCap), capital expenditure scaled by total sales (CapExp), 6 In Piotroski and Roulstone (2005) and Sias and Whidbee (2010), the authors suggest that option exercised by insiders ( ) in a firm reflect insiders beliefs of future firm performance on their stock-based compensations. Since this variable is only available after in COMPUSTAT, this study includes this variable in an unreported regression in robustness check. 14

15 market value to book value ratio (MtoB), research and development expenditure scaled by total sales (RD), long term debt scaled by book assets (Leverage), natural log value of shares traded (Liquidity), and the total property, plant and equipment costs scaled by total sales (PPE). Last, and are industry dummies, as classified by Fama and French 12-sector industry classification, and year dummies. V. Empirical Results 5.1 Performance around Stock Splits In Table 4, I report the abnormal performance of splitting firms as compared with the value- and equally weighted matched portfolios. Panel A shows the abnormal returns of splitting firms before split announcements over different observation periods, as early as 30 days before the split announcement day 0. The results show that, over short periods, splitting firms accrue an average of 1.1% over a 3-day announcement period, which is smaller than that reported in Ikenberry and Ramnath (2002) (3.4%) and Chen et al. (2011) (3.07%). However, their samples are matched with a single firm within the same ranks of size, value and momentum, rather than a weighted portfolio. The abnormal return of splitting firms on average is still 0.6% higher than their value- and equally-weighted portfolios, respectively. In addition to the short-run performance, the long-term abnormal returns of splitting targets centered at the split announcement date are shown in Panel B of Table 4. The average (median) 12-month buy-and-hold return for splitting firms is 7.2% (8.8%), and is 3.9% (2.1%) and 2.2% (2.5%) lower than the buy-and-hold returns of the value- and equally weighted matched portfolios in the corresponding period. While studies by Ikenberry, Rankine, and Stice (1996), Ikenberry and Ramnath (2002), and Chen et al. (2011) report a positive abnormal buyand-hold return of splitting firms, studies by Byun and Rozeff (2003) report no significant difference of 12-month buy-and-hold returns between split sample firms and matched portfolios. The operating performances of the split sample and their matched portfolios around split announcements as computed by the operating cash flow and by the return on asset are shown in Panel C of Table 4. The splitting sample has higher OCF and ROA than their matched portfolios both before and after split announcements. The average (mean) difference of OCF between the 15

16 split sample and the value-weighted portfolio is 7% (9%) 1 year before the split event, and 8% (9%) 1 year after the split event. The gaps drop if the split sample is compared to the equallyweighted portfolio, with a significant mean (median) difference of 4% (3%) in 1 year prior to and 4% (2%) after split announcements. These results hence are consistent with studies that show splitting firms enjoy higher earnings both before and after split announcements (Lakonishok & Lev, 1987; Piotroski & Roulstone, 2005). The results do not vary too much and the differences between split sample and matched portfolios stay positive and significant using different periods and using ROA to proxy for operating performance. 5.2 Insider Trading and Post-split Firm Performance In Table 3 and Figure 1, it indicates that insiders behave in a contrarian way by selling, instead of buying, their companies stocks before stock splits when the share returns appreciate consequentially. However, since the increasing trend in their monthly selling transactions starts as earlier as two years ago before announcement date, their abnormal trading behaviors cannot be purely attributed to reaction to coming split events. Given that several studies have shown insiders ability to predict future firm performance (Jiang & Zaman, 2010; Piotroski & Roulstone, 2005), it is of more interest to see whether insiders are informed of future corporate prospects and they react to their private information by trading early. One way to test for this utilization of private information is to see insiders trading behaviors prior to split announcements are related to post-split operating performance. If insiders predict a promising future of their firms, then I hypothesize that insiders in that category will have less selling (or even more buying) transactions beforehand than insiders from companies with poor future performance. To test for this hypothesis, the whole sample is broken into quartiles based on split targets future operating performance. Figure 2 plots insiders net purchase ratios among four quartiles based on splitting firms future abnormal operating cash flows in the following 1, 2, and 3 relative years after splitting quarter in an ascending order. Quartiles 1 has the lowest future operating cash flow and quartile4 operates best in the future. Across all figures shown in figure 2, they all indicate that, the net buying ratios of quartile 4 are higher than those of other quartiles. Hence, even though insiders do trade like contrarians before stock splits, they also adjust their trading based on future operating performance of firms. Insiders from firms with the highest operating performance in 16

17 the future do not sell as aggressively as insiders from other quartiles. On the other hand, if insiders are pessimistic about firm future performance, then they tend to sell rather than hold (or buy) their shares before stock splits. In Table 5, the mean and median net purchase ratios of insiders in quartiles and the difference between quartile 1 and quartile 4 based on split firms future operating cash flow are presented. Consistent with previous results, insider net buy ratios are negative across all four quartiles. From the left to the right side of the table, the net purchase ratios are increasing from quartile 1 to quartile 4. The 10 th and 11 th columns present the mean difference and median difference of insider net purchase ratios between the top and the bottom. The mean net purchase ratios, computed from numbers of shares traded, the dollar value of trades by insiders, and the number of transactions by insiders, are -19.6%, -19.6%, and -18.3% during three months prior to splits for quartile 4 with the highest post-split operating cash flow in the following 1 year after splits, respectively. And these ratios are significantly higher than those of the bottom quartile 1, which result in differences of 9.3%, 9.3%, and 9.6% in three net purchase ratios. The significant pattern of high net purchase ratios of quartile 4 over quartile 1 does not change if different periods are used or if the quartiles are classified based on post 2-year or 3-year operating cash flows. In Table 6, the four quartiles are formed based upon post-split operating ROA, instead of cash flow, and the comparison between the top quartile and the bottom quartile remains positive and significant regardless of the net purchase ratios used and the evaluating periods used. To sum up, the univariate tests as presented before indicate that insiders do trade in a contrarian way before stock splits; however, since they possess unique private information regarding to firm future performance, their pre-split trading behaviors are also adjusted to the quality of their information. 17

18 Reference: Beneish, M. D., & Vargus, M. E. (2002). Insider Trading, Earnings Quality, and Accrual Mispricing. The Accounting Review, 77(4), doi: / Bonaimé, A. A., & Ryngaert, M. D. (2013). Insider trading and share repurchases: Do insiders and firms trade in the same direction? Journal of Corporate Finance, 22(0), doi: Brennan, M. J., & Hughes, P. J. (1991). Stock Prices and the Supply of Information. The Journal of Finance, 46(5), doi: / Byun, J., & Rozeff, M. S. (2003). Long-Run Performance after Stock Splits: 1927 to The Journal of Finance, 58(3), doi: / Carline, N. F., Linn, S. C., & Yadav, P. K. (2009). Operating performance changes associated with corporate mergers and the role of corporate governance. Journal of Banking & Finance, 33(10), doi: Chen, H., Nguyen, H. H., & Singal, V. (2011). The information content of stock splits. Journal of Banking & Finance, 35(9), doi: Clarke, J., Dunbar, C., & Kahle, K. M. (2001). Long-run performance and insider trading in completed and canceled seasoned equity offerings. Journal of Financial and Quantitative Analysis, 36(4), doi: / Conroy, R. M., & Harris, R. S. (1999). Stock Splits and Information: The Role of Share Price. Financial Management, 28(3), doi: / Devos, E., Elliott, W. B., & Warr, R. S. (2014). CEO Opportunism? Option Grants and Stock Trades around Stock Splits. Journal of Accounting and Economics (Forthcoming). Givoly, D., & Palmon, D. (1985). Insider trading and the exploitation of inside information: Some empirical evidence. Journal of business, Gombola, M. J., Lee, H. W., & Liu, F.-Y. (1999). Further Evidence on Insider Selling Prior to Seasoned Equity Offering Announcements: The Role of Growth Opportunities. Journal of Business Finance & Accounting, 26(5-6), doi: / Grinblatt, M. S., Masulis, R. W., & Titman, S. (1984). The valuation effects of stock splits and stock dividends. Journal of Financial Economics, 13(4), doi: Ikenberry, D. L., & Ramnath, S. (2002). Underreaction to Self-Selected News Events: The Case of Stock Splits. The Review of Financial Studies, 15(2), doi: / Ikenberry, D. L., Rankine, G., & Stice, E. K. (1996). What Do Stock Splits Really Signal? The Journal of Financial and Quantitative Analysis, 31(3), doi: / Jaffe, J. F. (1974). Special information and insider trading. Journal of business, Jenter, D. (2005). Market Timing and Managerial Portfolio Decisions. The Journal of Finance, 60(4), doi: / Jiang, X., & Zaman, M. A. (2010). Aggregate insider trading: Contrarian beliefs or superior information? Journal of Banking & Finance, 34(6), doi: John, K., & Lang, L. H. P. (1991). Insider Trading around Dividend Announcements: Theory and Evidence. The Journal of Finance, 46(4), doi: / Ke, B., Huddart, S., & Petroni, K. (2003). What insiders know about future earnings and how they use it: Evidence from insider trades. Journal of Accounting and Economics, 35(3), doi: 18

19 Lakonishok, J., & Lev, B. (1987). Stock Splits and Stock Dividends: Why, Who, and When. The Journal of Finance, 42(4), doi: / Lee, I. (1997). Do Firms Knowingly Sell Overvalued Equity? The Journal of Finance, 52(4), doi: /j tb01116.x Ma, Y., Sun, H.-L., & Yur-Austin, J. (2000). Insider trading around stock split announcements. The Journal of Applied Business Research, 16. Penman, S. H. (1982). Insider Trading and the Dissemination of Firms' Forecast Information. The Journal of Business, 55(4), doi: / Pettit, R. R., & Venkatesh, P. C. (1995). Insider Trading and Long-Run Return Performance. Financial Management, 24(2), doi: / Piotroski, J. D., & Roulstone, D. T. (2005). Do insider trades reflect both contrarian beliefs and superior knowledge about future cash flow realizations? Journal of Accounting and Economics, 39(1), doi: Rozeff, M. S., & Zaman, M. A. (1998). Overreaction and Insider Trading: Evidence from Growth and Value Portfolios. The Journal of Finance, 53(2), doi: / Seyhun, H. N. (1986). Insiders' profits, costs of trading, and market efficiency. Journal of Financial Economics, 16(2), doi: Seyhun, H. N. (1992). Why does aggregate insider trading predict future stock returns? The Quarterly Journal of Economics, 107(4), Sias, R. W., & Whidbee, D. A. (2010). Insider Trades and Demand by Institutional and Individual Investors. The Review of Financial Studies, 23(4), doi: /

20 Table 1: Split Sample Distribution This table provides the frequency of the study sample by year (Panel A), by split factor to adjust price (Panel B), and by Fama and French 12-sector industry classification (Panel C). Panel A: Sample distribution by year Year Frequency Percent (%) Total 2, Panel B: Sample distribution by split factor to adjust price Split Factor Frequency Percent (%) < , > Total 2, Panel C: Sample distribution by Fama and French 12-sector industry classification Industry Frequency Percent (%) Business Equipment Chemicals and Allied Products Consumer Durables Consumer Non-Durables Energy Healthcare, Medical Equipment, and Drugs

21 Manufacturing Telephone and Television Transmission Wholesale, Retail, and Some Services Other (Mines, Constr, BldMt, Trans, Hotels, Bus Serv, Entertainment) Total 2,

22 Table 2: Descriptive Statistics This table provides the descriptive statistics of firm characteristics for 2016 splitting firms, their valueweighted portfolio, and their equally weighted portfolio over the period from 1991 to Asset is the natural logarithm value of book value of total assets. MktCap is the natural logarithm of market value of the firm. Capexp is the capital expenditure scaled by total sales. RD stands for the Research and development expenditure, scaled by total sales. Leverage is defined as the long term debt scaled by its book assets. Liquidity is the natural log value of shares traded. MtoB stands for the market value to book value ratio. PPE is the total property, plant and equipment costs, scaled by total sales. OCF stands for the operating cash flow and is calculated as operating income before depreciation and nonrecurring items, deflated by market value of assets. ROA stands for return on assets and is defined as the net income divided by total assets. ME is the raw market value of a firm (in millions). Ret12m and Ret36m are the average returns over previous 12 months and 36 months, respectively. Panel A: Split sample Variable N Mean Minimum 25% Median 75% Maximum Std Dev Asset 2, MktCap 2, Capexp 2, RD 2, Leverage 2, Liquidity 2, MtoB 2, PPE 2, OCF 2, ROA 2, ME 2, Ret12m 2, Ret36m 2, Panel B: Value-weighted Matched Portfolio Asset 2, MktCap 2, Capexp 2, RD 2, Leverage 2, Liquidity 2, MtoB 2, PPE 2, OCF 2, ROA 2, ME 2, Ret12m 2, Ret36m 2, Panel C: Equally-weighted Matched Portfolio Asset 2, MktCap 2, Capexp 2,

23 RD 2, Leverage 2, Liquidity 2, MtoB 2, PPE 2, OCF 2, ROA 2, ME 2, Ret12m 2, Ret36m 2,

24 Table 3: Insider Net Purchase Ratios before Split Announcements This table presents the insider purchase ratios before stock split announcements during different windows. The net buy ratio of insiders is calculated as the difference between buying and selling transactions to the sum of buying and selling transactions by all insiders in each month for each firm. Insider trading behaviors are measured based on the number of shares traded, the value of shares traded, and the number of transactions. Window Number of Shares Traded Value of Shares Traded Number of Trades (Month) Mean Min Max Std Dev Mean Min Max Std Dev Mean Min Max Std Dev (-36, -1) (-24, -1) (-12, -1) (-6, -1) (-3, -1)

25 Table 4: Abnormal Performance around Split Announcements This table reports performance for the split firms and their value-weighted (VW) portfolio and equally weighted (EW) portfolio. Panel A examines the returns for different observation periods around or after split announcements. The announcement period is defined as the three days around announcement day, from day -1 to day +1, where day 0 is the announcement day. The abnormal performances of splitting firms are measured by the paired differences of performance measures over their value- and equally weighted portfolios. Panel A reports the cumulative abnormal returns and return differences between splitting firms and their VW- and EW- portfolios around split announcements. Panel B reports the post-split buy-and-hold returns and return differences between splitting firms and their VW- and EW- portfolios around split announcements. Panel C reports the operating performance, as measured by operating cash flow (OCF) and return on assets (ROA), and performance differences between splitting firms and their VW- and EW- portfolios around split announcements. Panel A: Abnormal Return Sample VW Portfolio Sample - VW EW Portfolio Window ( N = 2016 ) ( N = 2016 ) Portfolio ( N = 2016 ) Sample - EW Portfolio (day) Mean Median Mean Median Mean Diff Median Diff Mean Median Mean Diff Median Diff ( -30, +1 ) 0.093*** 0.072*** 0.070*** 0.045*** 0.021*** 0.018*** 0.064*** 0.054*** 0.028*** 0.020*** ( -10, +1 ) 0.025*** 0.020*** 0.018*** 0.014** 0.007*** 0.004*** 0.017*** 0.018*** 0.008*** 0.005*** ( -5, +1 ) 0.019*** 0.014*** 0.010*** 0.008*** 0.008*** 0.004*** 0.010*** 0.010*** 0.009*** 0.004*** ( -2, +1 ) 0.014*** 0.010*** 0.007*** 0.006*** 0.006*** 0.002*** 0.007*** 0.007*** 0.007*** 0.003*** ( -1, +1 ) 0.011*** 0.007*** 0.005*** 0.004* 0.006*** 0.002*** 0.004*** 0.005*** 0.006*** 0.002*** ( 0, +1 ) 0.007*** 0.003*** 0.002*** 0.002*** 0.005*** 0.001*** 0.002*** 0.003*** 0.005*** 0.001*** Panel B: Buy-and-hold Return Sample VW Portfolio Sample - VW EW Portfolio Window ( N = 2016 ) ( N = 2016 ) Portfolio ( N = 2016 ) Sample - EW Portfolio (month) Mean Median Mean Median Mean Diff Median Diff Mean Median Mean Diff Median Diff (-36, -1) 1.378*** 1.205*** 1.467*** 1.139*** *** *** 1.236*** 0.028*** (-24, -1) 1.074*** 0.904*** 1.138*** 0.845*** *** *** 0.904*** 0.037*** 0.015*** (-12, -1) 0.686*** 0.537*** 0.748*** 0.507*** *** *** 0.547*** (+1, +12) 0.072*** 0.088*** 0.111*** 0.100*** *** *** 0.095*** 0.121*** *** *** (+1, +24) 0.166*** 0.189*** 0.227*** 0.208*** *** *** 0.193*** 0.242*** *** * (+1, +36) 0.264*** 0.284*** 0.327*** 0.286*** *** *** 0.286*** 0.324***