Investment Research and Inside Information

How far is it reasonable to go in pursuit of information

The investment research process is complicated by the blurred line between publicly available and inside, or privileged, information. 

Although trading based on inside information is illegal, the term has never been clearly defined. 

As investors seek to analyze investments and value securities, they bump into the unresolved question of how far they may reasonably go in the pursuit of information. 

• For example, can an investor presume that information provided by a corporate executive is public knowledge (assuming, of course, that suitcases of money do not change hands)? 
• Similarly, is information that emanates from a stockbroker in the public domain? 
• How about information from investment bankers? 
• If not the latter, then why do investors risk talking to them, and why are the investment bankers willing to speak? 

How far may investors go in conducting fundamental research? 

• How deep may they dig? 
• May they hire private investigators, and may those investigators comb through a company’s garbage?
• What, if any, are the limits? 

Do different rules apply to equities than to other securities? 

Debt market

The troubled debt market, for example, is event driven. 

Takeovers, exchange offers, and open-market bond repurchases are fairly routine. 

What is public knowledge, and what is not? 

• If you sell bonds back to a company, which then retires them, is knowledge of that trade inside information? 
• Does it matter how many bonds were sold or when the trade occurred? 
• If this constitutes inside information, in what way does it restrict you? 
• If you are a large bondholder and the issuer contacts you to discuss an exchange offer, in what way can that be construed as inside information? 

When does inside information become sufficiently old to no longer be protected? 

• When do internal financial projections become outdated? 
• When do aborted merger plans cease to be secret? 

There are no firm answers to these questions. 

Stay within the law, err on the side of ignorance or seek advice

Investors must bend over backward to stay within the law, of course, but it would be far easier if the law were more clearly enunciated. 

Since it is not, law abiding investors must err on the side of ignorance, investing with less information than those who are not so ethical. 

When investors are unsure whether they have crossed the line, they would be well advised to ask their sources and perhaps their attorneys as well before making any trades. 

Conclusion 

Investment research is the process of reducing large piles of information to manageable ones, distilling the investment wheat from the chaff. 

There is, needless to say, a lot of chaff and very little wheat. 

The research process itself, like the factory of a manufacturing company, produces no profits. 

The profits materialize later, often much later, when the undervaluation identified during the research process is first translated into portfolio decisions and then eventually recognized by the market. 

In fact, often there is no immediate buying opportunity; today’s research may be advance preparation for tomorrow’s opportunities. 

In any event, just as a superior sales force cannot succeed if the factory does not produce quality goods, an investment program will not long succeed if high-quality research is not performed on a continuing basis.