The Insider's Guide to Director's Dealings

Whenever you approach the stock market it's worth considering that the guy on the other side of the trade is probably better informed than you are. When you are buying, he's selling, when you are selling, he's buying. One of you has to be the mug.

While the regulators have done their best to ensure that price sensitive information about companies is fairly disclosed, there are still plenty of individuals who are much, much closer to a company than you are. The closest are known as company 'insiders' who include company directors, officers but also large 10%+ shareholders who may have access on a daily basis to the kind of sensitive business information most shareholders would die for. It genuinely pays to know what they are up to before you make your own moves as they are often acting confidently based upon hard business data.

The tracking of insider trading (more commonly known as director dealing in the UK) has long been known to be a very profitable pursuit. Studies suggest that simple strategies following clustered director dealing can return anywhere from 5% to 10% or so greater than the market averages on an annual basis. The gotcha is that the profits are quite lumpy - sometimes the strategy can underperform for a couple of years before outperforming again - and not many people can handle that.

What works in director dealings?

While the profitability is well known, what is less known are the ins and outs of who's trades are worth tracking and for how long. There have been reams of academic studies since the the 1960s which have aimed to figure out precisely how best to profit from insider trades which we'll summarise briefly today as the rules.

Rule 1: Buy signals are more powerful than sell signals This may seem counter-intuitive, but it's a fact. Most investors are terrified when they see a director sell, but the truth is that selling shares is more often than not for personal reasons (buying a house, diversifying, cashing out options) rather than for reasons relating to the company valuation or prospects. In general there is no correlation with directors sales and lower future stock returns on a per stock basis except when stocks are on very high valuations. In contrast insider purchases do have more widespread predictive value… especially when in unison with Rule 2.

Rule 2: Focus on intensive buying by multiple directors By far the best signals are those where there are signs of 'cluster buys'. When more than three directors in the previous three months have bought a stock, returns on average are 2% per month higher than the market. There are various other ways to calculate the buying intensity. Some use the 'Net purchase ratio' which is the difference between buys and sells compared to the total, while others simply look for cases where the number of buyers is greater than the number of sellers plus 2. Regardless ot technique, buying intensity is the single most important factor.

Rule 3: Act on buy signals as quickly as possible To really profit from insider signals it pays to act very, very quickly as soon as you can after the information is released to the market. While insider trades are profitable signals for the first 9 months after they are disclosed, on average about half of the profits are made within the first 60 days, while a quarter are made in the first 10 days. The great advantage that individual investors have is that they can trade in small size, seizing on these market inefficiencies in a way that hedge funds can't.

(Image from The Handbook of Equity Market Anomalies)

Rule 4: It pays to track the directors rather than officers Company directors have a very special role, they are members of the company board and sit in on board meetings. Board meetings are really the only place where everything about a company is discussed openly and where the most sensitive information is shared. While all directors are company officers, not all officers are directors. Clearly one would expect that executive director buying (especially the CEO and CFO) is more valuable than other regular officer buying and the data bears this out. 10%+ shareholders also seem to have more information than company officers. Place your bets with the board.

Rule 5: Focus on larger trades in smaller value stocks Director purchases also seem to have more value when stocks are very cheap, especially when distressed. There are also higher returns from following dealings in small and micro cap stocks where it's much harder for hedge funds to deal effectively and in size.

Rule 6: Focus on companies in less cyclical sectors Some of the worst returns from insider trades occur in companies in cyclical sectors - such as in the energy and mining sectors. These sectors have profit cycles tied more closely to macro-economic factors. It's better to zero in on director buying in consumer staples, finance, services and technology stocks. There's almost double the profits to be made trading off director signals in consumer defensives (food, beverages etc) than consumer cyclicals (housing, cars etc).

The Stockopedia InsiderRank

All the above factors we will shortly be aggregating in true Stockopedia style into a ranking for every company in the market. While our research is ongoing, the Stockopedia InsiderRank may be the first data point of its kind published on the web for UK companies. Our hope is to make it much easier for subscribers to find the deals that matter - separating the signal from the noise and helping you harvest greater stock market profits.

While this module may not be released until late October we'll be giving sneak previews to current subscribers. Do sign up for a free trial and we'll keep you posted.