Keeping a close eye on the share trading activities of company directors can offer some excellent pointers to where those share prices might be heading next. But while details of “directors’ dealings” are widely available, it’s essential to know precisely how to use them and what to look for if you’re ever going to profit from boardroom buying.
Researchers have spent years studying what happens when directors buy and sell shares in the companies they run. Unsurprisingly, the great weight of evidence shows that when they buy their own shares, the price tends to rise over subsequent months. And why wouldn’t it? In theory, company insiders, particularly senior directors, ought to be the best judges of their own stock’s future prospects. So when an FD or CEO buys a meaningful chunk of shares in their own company, it may be reason for regular investors - or outsiders - to take a closer look. For smart money investment firms, this is an entirely plausible way of playing the market and specialist funds that track directors’ dealings are nothing new. Indeed, in 2010, a hedge fund called Swiss Investment Managers was set up to solely invest on the back of directors’ dealings.
Reading between the lines
Unfortunately, while the premise of taking a lead from directors sounds like a useful investing strategy, it hits trouble when you realise that not all directors’ dealings tell the same story. Neither do they all have the same impact on share prices. To illustrate this, it’s worth quickly exploring one of the biggest areas of confusion in directors’ dealings - the moment a director actually sells shares. For many investors, news that a board member is offloading stock can be tantamount to treason but it may not always be bad news. While it’s difficult to argue that a director selling stock is giving anything other than a negative message, research shows that generally these sales don’t damage share prices permanently. The fact is that a high proportion of director share sales are used to fund things like school fees, new houses, messy divorces and reduce portfolio exposure - and the market frequently acknowledges this.
Meanwhile, share purchases by directors are frequently interpreted as value-driven decisions designed to make a profit. But even here, researchers have found that it’s important to scrutinise the size and value of the purchase, who the director is and whether the trade coincides with corporate newsflow. Likewise, one of the most important patterns in directors’ dealings is cluster buying, or periods when several directors are snapping up stock. These ‘high conviction’ trades are some of the most predictive of share price outperformance. They also dramatically reduce the risk of misinterpreting ad hoc buying and selling by directors that may otherwise mean very little.
A boost to value strategies
Analysis of these cluster buying events has found that the higher the number of net purchases by multiple directors over the past three months, the more profitable those trades will tend to be for the directors involved (Seyhun, 1986). Moreover, for outsiders, the recent history of purchases has been found to be a key driver of outperformance (Daniel Giamouridis, et al, 2008). Interestingly, Giamouridis managed to exploit the directors’ dealings anomaly by introducing it as an additional component in a value and momentum portfolio. As it turned out, their basket of cheap stocks on the move did produce better returns when those shares were also ranked for high levels of conviction buying by directors. More recent research has also found that directors have a tendency to be contrarian investors with a preference for buying value and selling glamour shares. Analysis by a research team from Exeter University Business School found that directors’ trades in small value stocks showed an average abnormal share price return of up to 20% more than control groups of similar firms over two years.
The good news for Stockopedia subscribers is that ranking every company in the market for value, momentum, growth and quality characteristics is simple using StockRanks. Likewise, in the coming weeks we’ll be introducing a handy InsiderRank, which will offer an accurate way of analysing directors’ dealings.
Hunting for cluster buys
With evidence suggesting that buying is a far more important indicator than selling, it’s clear that directors’ dealings can be a hugely revealing guide for outsiders. But while there are strict market rules in place for reporting when directors have bought and sold shares in their own companies, profiting from this information isn’t entirely straightforward. However, cluster buys involving several directors over recent months is not only one of the most intuitive indicators when it comes to these trades, but the evidence suggests it’s also one of the most profitable.
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