Director dealings – Can insider share trading influence returns?

Wednesday, Dec 19 2012 by
6
Director dealings  Can insider share trading influence returns

In brief 

Many investors take an active interest in the buying and selling of shares by company directors. While insider share dealing is governed by very strict rules related to how and when trades can be made, some evidence suggests that following these transactions can be an effective way to produce abnormal returns. After all, those individuals on the inside theoretically have the best knowledge of the future prospects of the stock. 

Background 

Every day, financial media outlets such as the Financial Times, publish details of quoted-company directors that have been trading their own stock. Both UK Listing Rules and AIM Rules restrict directors and persons discharging managerial responsibilities (PDMRs) from dealing in ‘close periods’ and at other times when there is undisclosed price-sensitive inside information. This means that directors can’t trade their stock less than 60 days ahead of annual results and annual reports (unless the results are published sub-60 days after the year-end). Neither can they trade in the period between the end of the half-year and the publication of the interim results. While the precise details vary slightly between exchanges, directors are generally required to seek authority for their share dealing and disclose their activity. In turn, the company must promptly disclose director dealings to the market. 

Investment strategies 

Because of the amount of interest in director dealings there has been a considerable amount of research into whether insiders can themselves produce abnormal returns from trading and whether outsiders can benefit by mimicking those trades. Early research by Jaffe (1974) and Finnerty (1976) found that using director dealings as a signal produced abnormal returns to varying degrees in subsequent months. In 1985 Givoly and Palman reached a similar conclusion but argued that insiders could make these abnormal returns because their actions were copied by investors, which consequently moved the share price. Later work by Jeng, Metric and Zeckhauser (2002) looked specifically at the gains made by insiders and found that insider purchases earn abnormal returns of more than 6% per year, while insider sales do not earn significant abnormal returns. 

Despite evidence that insiders are capable of predicting abnormal returns, academic research into whether outsiders can take advantage of tracking director dealings presents a mixed picture. In one of the largest studies of the subject, Seyhun (1986) explored the implications of firm size and liquidity related to director dealings. He found that while insiders typically purchase stock prior to an abnormal rise in price and sell stock prior to an abnormal decline in price, for outsiders, the ability to mimic these trades profitably is hampered by trading costs. In the case of smaller stocks, which are typically susceptible to wide bid-ask spreads, these costs can diminish the returns considerably, if not completely. 

Those findings were corroborated in research by Lakonishok and Lee (2001), which scrutinised one million trades in the period 1975 to 2005. They observed:

“Insiders have many reasons to sell shares but the main reason to buy shares is to make money.” 

What they found was that using director dealings as a signal is not straightforward but that it is a comparatively strong indicator in small cap stocks. They looked specifically for strong buy and sell signals and found that when at least three different insiders are trading sizable amounts of stock this produced high returns. However, for large companies, even strong buy signals convey almost no information. Lakonishok and Lee found that companies with extensive insider purchases over the past six months outperform companies with extensive sales by 7.8%, with the spread in return reducing to 2.3% in the second year. 

 Special Offer: Invest like Buffett, Slater and Greenblatt. Click here for details »

In the UK, studies into director dealings have broadly matched those carried out in the US. A study of UK activity between 1984-1988 by Gregory, Matatko, Tonks and Purkis (1993) concluded that abnormal returns can be earned using a simple strategy of buying or selling shares following director dealings. However, they found that a large proportion of these abnormal returns occurred in small and medium sized firms, meaning that the findings could simply reflect the “size effect” that smaller firms tend to outperform the market anyway. Controlling for beta and size, the UK researchers found that returns achieved from following directors’ dealings became less significant for buy signals and insignificant for sell signals. 

Can it work? 

In the excellent Handbook of Equity Market Anomalies from Zacks Investment Research, Ian Dogan of Insider Monkey presents a long/short portfolio based on director dealings for the period 1978-2005. His long portfolio includes companies that are larger than the median NYSE firm and operate in one of the following sectors: transportation, technology, consumer staples, services, financial. Dogan’s portfolio requires three insider purchases in the three months preceding the insider purchases. After taking into account an annual 8% transaction cost, the long/short insider trading portfolio achieved an annual return of more than 10%. 

What to watch 

While Dogan’s portfolio produced consistent high returns, he acknowledged that it displayed high volatility and inconsistency. Even though it had no market exposure, the portfolio’s standard deviation was more than 50% above the market's standard deviation. There were also long time periods when the portfolio underperformed the market even though, on the average, it beat the market. 

We'll soon be adding the ability to screen for Insider Buying to Stockopedia Premium. As a reminder, we are still offering a free trial for those who haven't yet tried the product. 

Further reading 

 


Filed Under: Director Dealings,
There's value in the stock market
but do you know where to look?

Get the most concise synopsis of everything that's been proven to work in value investing. If you like your stocks cheap you've found a treasure trove distilled to under 70 pages.

  • How to find ultimate Bargain Stocks with Ben Graham
  • How to spot Turnarounds and avoid Value Traps
  • From Graham to Greenblatt via Piotroski & Lakonishok
  • How to value stocks and set a margin of safety

Soon to be retailing for an RRP of £14.99, for a limited time only,
you can get your copy free by joining our 35,000 strong mailing list.

*By signing up you'll be joining our mailing list
no junk, no spam - just great content like this example.


Disclaimer:  

As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested.


Do you like this Post?
Yes
No
6 thumbs up
0 thumbs down
Share this post with friends




3 Comments on this Article show/hide all

mikelevie 7th Aug '13 1 of 3
2

Hi, when do you plan to add the Insider Buys to the screening criteria?

Thanks,
Mike.

| Link | Share | 1 reply
Murakami 7th Aug '13 2 of 3
1

In reply to mikelevie, post #1

Hi, it's best to hit the Green Button for product queries like this as the response time will be faster / more detailed, but, just quickly on this one, we're aiming to launch this in Q4 this year.

| Link | Share
mikelevie 7th Aug '13 3 of 3

Of course, should know that by now. Many thanks for the update, looking forward to this new functionality.

| Link | Share

What's your view on this article? to Comment Now

 
 
You are feeling neutral

Use the £ sign in front of a ticker to turn £VOD into Vodafone PLC

You can track all @StockoChat comments via Twitter


About Ben Hobson

Ben Hobson

Follow

Strategies Editor at Stockopedia. Writer, Editor & Investment Strategies Analysis. Test driving and telling the world about the awesome stock market investing tools and resources at Stockopedia. Helping Stockopedia subscribers take control, invest with confidence, beat the market and sleep soundly at night. more »


Stock Picking Tutorial Centre



Stock Picking Simplified

Stockopedia takes your stock picking to the next level with cutting edge Stock Reports & Screening tools.


Get started
or Take a Tour to find out more.