The best way to explain how to use the trading moves of company insiders is with an example.  In the spring of 2011, the shares of tobacco giant Lorillard, Inc. (NYSE: $LO) caught my attention.

Lorillard is the third largest manufacturer of cigarettes in the United States and the oldest continuously operating tobacco company. Newport, Lorillard’s premium menthol-flavored cigarette brand, is the top-selling menthol and second-largest-selling cigarette in the United States.

I’ve made the case for “Vice Investing” repeatedly in the Sizemore Investment Letter, and I’ve given special attention to the tobacco industry.   To briefly summarize, tobacco companies are uniquely attractive investment for a number of reasons:

  1. Government regulation and the threat of lawsuits prevent new competitors from entering the industry.
  2. Many institutional investors with “socially responsible” mandates are not permitted to invest in tobacco.  This lack of institutional buying has the effect of lowering the valuation, thus making tobacco stocks perpetual value stocks. (For a detailed explanation of this phenomenon, see “The Price of Sin”)
  3. Tobacco companies generally pay very large and growing dividends.   The reinvestment of dividends is the single most powerful wealth compounding tool available to investors.

While Lorillard enjoys all of these benefits, in April of last year it also has the bonus of trading at a significant discount to its peers.  It has the lowest P/E and the highest dividend yield of major tobacco companies—a whopping 6.7%.

Lorillard’s depressed price was mostly due to fears that the Food and Drug Administration would make the company’s primary product—menthol cigarettes—illegal.  The FDA decided against such a move earlier in the month, yet the share price still reflected investor fears that bad regulatory news would be coming down the pipeline.

There was one person, however, who was conspicuously confident.  The company’s CEO Murray Kessler spent nearly a million dollars of his own money three months before buying shares of Lorillard on the open market.

Corporate insiders sell stock for any number of reasons.  They exercise stock options and liquidate the shares.  They sell off shares of their concentrated positions in order to diversify their portfolios.  They unload a few shares to buy a nice vacation home in the Hamptons.  There are infinite reasons why an insider might sell the shares of the company they help to manage.  But there is only one reason why they would buy.

When you see the man who runs the company putting his own money behind it, you can be reasonably certain that good news will be forthcoming.  While it is illegal for corporate insiders to trade on material non-public information, there is nothing at all illegal about them using their intimate knowledge of the company and industry to handicap the odds of, say, an FDA decision and trade accordingly.  I’ll trust the judgment of an informed insider over the uninformed masses.

In Lorillard I saw the conditions for the perfect trade lining up.  In Lorillard, we had:

  • A solid vice investment at an attractive price
  • A 6.7% dividend that was likely to grow in the coming quarters
  • Aggressive buying of the company’s shares by the CEO—a man who ought to know a thing or two about Lorillard’s prospects

As luck would have it, the trade worked out even better than I had hoped.  The FDA clarified their position on menthol cigarettes, and the shares of Lorillard rose over 40 percent in less than a month.

Not all trades work out this cleanly, of course.  There is not—and never will be—such a thing as a perfect, risk-free trading strategy.  In the case of Lorillard, it was entirely possible that the CEO could have been wrong or that the FDA arbitrarily changed its mind.  These things can and do happen

Still, following the trading moves of company insiders gives you one more tool at your disposal and allows you to trade with more confidence.  When you’re putting capital at risk, it pays to use every tool at your disposal.

This article originally appeared on InsiderEdge.com.