How to profit from inside knowledge

In one of my portfolio picks, four separate directors had bought shares at the same time. What do they know that we don’t know?

Last week I came across something interesting while checking up on the Penny Share Letter portfolio.

In one of the companies, four separate directors had bought shares at the same time. And they had bought lots of shares: 12% of the overall issued share capital between them.

Obviously it’s interesting news: what do they know that we don’t know?

But was it really important? Does director buying really say something about where the share price is going?

I’ve been digging into the research to find out.

Market abuse or smart strategy?

What do I mean by insider dealing? Well in the UK and the US, there are rules which limit company directors’ ability to buy and sell company shares. They’re not allowed to deal in during “closed periods”, i.e. the two months before the announcement of half year and full year results. And whenever they buy or sell shares in the permitted periods, they must disclose their dealings to the market.

Directors are forbidden from dealing in the closed period because there’s scope for market abuse. Directors, who have more information than the market, could for example buy extra stock before the company publicly discloses strong annual results.

There are other reasons why directors are different from ordinary investors. Yes, they have more information. But their incentives are different too. Often directors feel pressure to own a certain amount of company stock in order to give the impression of confidence in the business; so you’ll often see newly-appointed directors buying stock. And sometimes directors have a large slice of their net worth tied up in company stock, and will sell some stock to diversify their portfolio.

Director dealing has been restricted in the UK and the US for a very long time, so that’s where the research has been focused. The early studies in the 1970s found that insider buying had a significant positive effect on stock prices. That was followed up by research by Seyhun (1986), Rozeff and Zaman (1988), Lin and Howe, (1990) and Lakonishok and Lee (2001), which showed that company insiders make abnormally high returns by trading the stocks of their own companies. Vickrey, and Vickrey (1997) showed that not alone can insiders benefit from this, but that outsiders can profitably copy insiders and make significant profits.

And lots of smart investors put great store in director dealings. Jim Slater, author of The Zulu Principle, says insider dealing is “the most reliable sign shares will rise”.

The signs to watch

So, what should you look out for?

Well firstly, not all director dealing matters. A 2003 article in the Journal of Economics and Statistics by Jeng, Metrick and Zeckhauser found that insider sales did not predict a fall in stock prices, but insider buying predicted extra returns of 6% per year. As I mentioned previously, directors often have a big chunk of their wealth tied up in company stock. So they have a good reason to sell, whether or not the company is doing poorly.

Another scenario is where a newly appointed director joins the board. Again, that doesn’t necessarily mean the company is doing well. It might just mean the director is showing face.

Another thing to watch out for is the scenario that presented itself in my portfolio company last week – several directors buying at once. When directors buy together, you can be certain it’s not because of their own personal circumstances. It indicates that something has changed at the company.

The size of the deals matters. This may seem obvious but it’s worth mentioning. Every other month some company director will deal a little in company stock. Big deals are what matter.

Related to my previous point about new directors: sometimes, directors will buy stock just to give the impression of confidence in a troubled company. This was the case for one of my Penny Share Letter stocks, a house builder which stock got clobbered immediately after Brexit. The directors bought the stock at the lows as a sign of confidence, and the stock has added about 30% since then. That’s the happy scenario. On the other hand, directors of HBOS and other big banks were loading up on company stock right up to the end in 2008.

So there you go. I got the dream scenario last week, where directors bought shares of a company already in my portfolio. I didn’t have to trade the news. It just fell into my lap.

Should you actively trade based on director dealing? I wouldn’t think so. The research says it matters, so it’s definitely something that should go into your calculation if you’re considering buying a share. But trading solely on that one data point is a dicey strategy.

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