Importance of director deals

Employees trading stock in their employer can be a powerful share price catalyst.

‘There are many reasons insiders sell, but only one reason they buy.’ The old Wall Street adage is another way of saying that share dealing by directors is worth keeping a close eye on. They can send powerful signals to the stock market; yet it can often take days or weeks for most investors to latch on to the news of buying or selling, giving the savvy investor an advantage by making this a priority place to monitor.

Directors should know better than anyone else the true value of the businesses they run. Academics, investors and our own research indicate following smart money can be a successful strategy.

PROFITABILITY

A number of academic papers point to higher investment returns where there is heavy director dealing, as highlighted later in this article.

This is at odds with financial theory, which assumes all available information is incorporated into a stock price when announcements are released.

Constructing a ‘rolling purchase portfolio’ which contains all of the stocks which have been purchased by directors in a 12-month period, Boston University academic Leslie A. Jeng found monthly returns were around 40 basis points (0.4%) better than the market, or around 5% a year, for 12 months after an announcement.

Jeng’s research, published in 1999, was based on a sample of director dealings between 1975 and 1996 in the US. The results are based on buying shares at the end of the day a director bought shares. Purchases by directors showed positive future ‘abnormal’ returns – this means returns adjusted for risk – while director sale transactions showed no significant return pattern, positive or negative.

More recently, a 2008 report 'Some Insiders Are Indeed Smart Investors' finds a 2.9% excess return over a 120 day time horizon from when director share dealing was announced to the market. That translates to a 6.1% abnormal return on an annualised basis, assuming 250 trading days per year.

Based on UK stock market director dealing between 1994 and 2006, the academic researchers found portfolios could be created ‘that generated an economically and statistically significant return’.

‘In particular, immediately after a directors’ purchase announcement, we find that shares tend to outperform the market by 0.7%,’ says the report, which also included research from bankers at Citigroup.

‘We also find that stocks outperform by 1.2% between days one to 60 and by 2.9% between days 1 and 120. Other academic performance points to better excess returns for director dealings in smaller companies.

INVESTORS

Never mind the theory – what about those who are active in the market? Investors should take notice of director holdings and recent transactions, according to private investor Lord Lee of Trafford.

Lord Lee, whose book How to Make a Million – Slowly is based on a lifetime of investing in stock markets, says management sales of stock were a key reason he recently exited a position in convenience retailer McColl’s (MCLS).

Year-to-date, directors at the Brentwood, Essex-based business have sold a total of £735,000 worth of stock at today’s prices.

Part of Lord Lee’s investment approach is to identify listed firms with heavy insider ownership and long-term shareholders.

‘Essentially, to me, I will not invest in a company – or very rarely – unless the directors who are running it have significant investments in the business. And not in the form of options but committed shareholdings,’ Lord Lee explains.

‘Parallel to that, I have focused over the years and have benefited from investing in what I call “proprietorial” companies where there is a family shareholder base or a controlling position.

‘The reason for that is… there is the old saying from clogs to clogs in three generations… but there are a number of family businesses that have survived and prospered and the emphasis is on stewardship, which is an idea I’m very keen on.

‘The new generations running the business typically are very conscious of its history and the responsibility they have to future generations and shareholders to adopt a conservative approach to running the business they are in charge of. They are not taking risks, or betting the family silver on reckless pursuits.’

Examples of companies with heavy insider ownership within Lord Lee’s portfolio are consumer goods specialist PZ Cussons (PZC) and Nichols (NICL:AIM), owner of soft drinks brands Vimto, Sunkist and Panda.

GOLDEN RULES

Directors have to report to the stockmarket every time they buy or sell shares in their employer. The announcements usually contain the following information:

• Director's name
• The number of shares bought or sold
• The number of shares still held after this transaction – and what this represents as a percentage of the entire company's issued share capital. That will show you how much of the company they own
• Whether they have acquired the shares on the market or been given them as part of a bonus scheme or other remuneration

Unfortunately very few announcement give a reason why a director is buying or selling. You may occasionally get a line that says 'to diversify portfolio' or something about settling a tax bill. They will rarely comment on whether they see the shares as being cheap, hence why they are buying, or selling because they look expensive.

The general rule is that the bigger the size of the deal, the more significant it is.