One up on Gordon Gekko — Four rules to profit from director trading

There’s that stretch over the Christmas holidays when the days all blur together. You can't tell if it's December 27th or 28th. I passed the time with movies, starting with the Christmas classics (I was forced to sit through Muppet's Christmas Carol) before moving on to Oliver Stone's Wall Street. The film stars Michael Douglas, as the ruthless tycoon Gordon Gekko, and Charlie Sheen as Bud Fox, Gekko’s eager apprentice.

There’s that scene where Gekko needs share tips. Bud Fox produces some run-of-the-mill analysis. Gekko shoots back: ‘Come on, pal. Tell me something I don’t know… It’s my birthday!’ A bead of sweat drips down Bud's forehead as he searches the darker recesses of his mind, knowing that this is the point he should not cross.

‘Bluestar…’ Bud forces a response. ‘Bluestar Airlines! They just got a favourable ruling on a law suit. The decision would clear the way for new planes and route contracts.’

‘Well how do you know about it?’

Bud gulps. There is another stretch of silence as more sweat drips down his forehead. He can only muster, ‘I just know…’

Spoiler alert! Towards the end of the movie Bud is arrested. The information Bud passed on to Gekko was non-public, material information — ie. confidential information that would significantly move the share price. Bud and Gekko had engaged in insider trading, violating laws that ban the use of confidential information to gain an unfair advantage. Unfortunately, the movie is not pure fiction. The characters are based on real financiers. The events are based on real scandals.

Oliver Stone’s film was a piece of social commentary, suggesting that investing can be an unfair, corrupt game because some investors have significant informational advantages over others. Regulators work hard to ensure that price sensitive information about stocks is fairly disclosed. Nevertheless, there is an 'inner circle' with intimate knowledge of a company’s future prospects. Do investors need this intimate knowledge? Not necessarily. We don’t need to be part of an ‘inner circle’…

What if Gordon Gekko had to play fair?

Of course, white collar crimes do take place, but the game of investing is perhaps more fair than Oliver Stone's movie made it out to be. It’s true that information asymmetries will always exist. For instance, a CFO will have advanced knowledge of a company's financial performance. It is also legal for company directors to buy shares in the firms they manage. At the same time, various laws aim to level the playing field by requiring companies to disclose director trades — i.e. trades made by CFOs and CEOs and any other director that manages the operations of a company.

When directors trade, this can create opportunities for investors to piggyback directors’ transactions. This is a legal form of ‘insider dealing’, based on publicly available information. We've crunched the numbers and can pinpoint a series of signals that investors can use to capitalise on director transactions. Four samples were analysed:

• The first sample consists of director trades that make up a large percentage of market cap. We focus on the 200 largest trades.
• The second sample is the same as the first, but we filter for CEO and CFO trades which make up a large percentage of market cap. Again, we look at 200 trades.
• The third sample is a randomised selection of 200 CEO and CFO trades, regardless of the percentage of market cap.
• The fourth sample is another randomised selection of 200 trades, regardless of the job title and regardless of the percentage of market cap.

Rule 1: Director buys outperform director sells

It will come as no surprise that director buys have a tendency to outperform director sells. When a director buys shares in their own company, it is often seen as a signal that they have confidence in the company’s future prospects. The same is not necessarily true when a director sells shares, although there is a bit of nuance to unpack. Directors may sell for any number of reasons, such as purchasing a house, diversifying their wealth, or paying taxes. The star-fund manager Peter Lynch put it like this: ‘Insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise.’

There were even cases when director sells were followed by strong share price returns, so we need to explore additional criteria…

Rule 2: Focus on ‘C-suite’ transactions

While the signal from director buys is generally quite strong, the same is not true of director selling. That can be because some positive director sales can muddy the signal. For example, in January 2021, the founder of fleet tracking company Quartix Technologies (LON:QTX) sold shares for the first time since the company had been listed on the market. The reason given at the time was to free up space for institutional demand. Sure enough, a couple of months later, Sandford DeLand’s Buffettology fund had taken a stake in the business, prompting a positive share price reaction.

But we can add clarity to director sells by focussing specifically on trades by CEOs and CFOs. When ‘C-suite’ directors sell, the returns tended to be negative. We can also see that C-suite sells underperformed C-suite buys by a significant margin.

Rule 3: Focus on material buys in smaller companies

To increase the chances of identifying winning stocks, it can help to focus on a specific type of buy transaction. Research by Lakonishok and Lee revealed that director dealings are a stronger indicator in smaller companies. Analysing one million trades from 1975 to 2005, they discovered that returns were significantly higher when insiders traded substantial amounts of stock. This is broadly consistent with our own research. We found that director buys generated the strongest returns when the transaction represented a larger percentage of market cap. Naturally, these transactions tended to take place in smaller companies, where it is easier to buy a larger share of the company.

Table 1: Minimum and median amounts for largest buys as % of Mkt Cap

Rule 4: Don’t worry about missing the bus!

The ‘post-announcement drift’ is a fascinating trend in investing. It refers to the tendency of a company's stock price to continue rising steadily for weeks or even months after the announcement of favourable news. This phenomenon would puzzle someone like Issac Newton, who observed that what goes up must come down. During a ‘post-announcement drift’, shares that have gone up defy gravity and keep going up.

This phenomenon becomes easier to understand when we consider human psychology. For example, imagine yourself in a casino playing roulette. The wheel has just landed on red, and it has landed on red several times in a row. At this point, you might feel hesitant to bet on red again. The Russian novelist, Dostoevesky, described this behaviour in The Gambler:

A thing took place which is actually repeated quite frequently in gambling. Fortune attaches itself to red, for example, and does not abandon it for some ten or even fifteen times in a row. I heard just a couple of days ago that red came up last week twenty-two times in a row. Needless to say, everyone immediately abandons red, and after ten times, for example, almost nobody risks betting on it any more.

Re-read the passage, but this time replace "red" with "stock" and "gambling" with "investing." Dostoevsky observed how, in roulette, people tend to avoid the winning colour. If Dostoevsky had been a Wall Street trader, he might have noticed a similar behaviour among investors. There is often a reluctance to buy stock that have already gone up. Investors believe they have missed the bus and the tides may turn. With this mindset, they deliberate and buy cautiously over time.

As a result, stocks that announce good news often experience an initial sharp increase, followed by a more gradual upward drift over time. After a director buy, it can take as many as 96 trading days before a stock peaks out. There is a similar trend on the downside if CEO and CFOs are selling.

Next steps

We have the theory. Let’s put theory into practice. Director dealing data can be found on the website (see here). Investors will want to act on a trade that has happened within the last 100 trading days. We display the date of the transaction in the far-left column of the table.

It is also important to identify material trades — i.e. trades that comprise a larger percentage of market cap (e.g. at least 0.02%). The Value column displays the value of the transaction — i.e volume multiplied by price. We also show the market capitalisation towards the top of the StockReport (see here). The two figures can be used to calculate the transaction value as a percentage of market cap. In time, we will calculate this value, so you don’t have to.

Investors will also want to know who was trading. The names of the CEO and CFO are shown towards the bottom of the StockReport. We show the director deals in the table, so that investors can pay particular attention to ‘C-suite’ transactions.

Going forward, we plan to make it easier to analyse director trades on the site. If anyone has ideas, please do post them in the comments. In terms of the research, I would like to extend the analysis beyond small samples of 200 trades. It is unlikely that the big picture will change, but the analysis would of course be more robust if it encompassed a bigger pool of data. One thing I really want to nail down is the thresholds investors can use to identify a ‘large’ or ‘material’ trade. We can also run some backtests to ascertain exactly how many stocks investors need in their portfolio to profit from a director buy.