Why look at Directors Share Purchases?

by Simon Winfield

I’ve spent years and years listening to what directors of listed companies say. I find their body language, relationships with each other, and what they don’t say to be much more informative.

I’ve also started to analyze their share dealings. My theory is that it’s what directors do with their own money that sends the real message about how investable their company is.

Actions speak louder than words.

For many years I have sat in meetings between company management and investors. The company have prepared themselves for the presentation, they know the investor well, or if they don’t they will have a very clear knowledge of the likely course of the discussion. Therefore they have prepared answers.

An investment in the company by the director themselves, in cash, is a clear signal of the directors perception as to the current valuation of the company’s shares. In the US this is termed ‘insider activity’ or ‘insider dealings’, the director being an ‘insider’ at the company.

Options, Executive share schemes, and other methods of increasing directors ownership are often imposed on the directors by the company, or offered as a way of buying half price shares by the director (in the cases where the company matches the executives purchase). It is believed that an increased ownership by directors aligns them more closely with investors. These are therefore not a cash investment by the director, and in my view should not be taken as a signal by investors.

The big caveat in using directors dealings is that you need to be fairly long term in your outlook when using them as a criterion for investing. Directors are limited as to when they can legally buy and sell shares. They cannot trade between the closing of the financial period and the reporting to the market of that information, often two months later. Companies report at least twice yearly, sometimes quarterly, so the dealing ‘window’ available to directors is oftentimes very narrow, and not necessarily the optimum time, price wise, to buy or sell shares.

‘Insider purchases, and not analyst recommendations, possess incremental predictive power for future stock returns’ (Hsieh, Ng and Wang, 2003- Analyst Stock Recommendations and Insider Trading Activities.

Directors vs Non Executive Directors

Executive Directors are involved in the day to day running of the business. They have intimate detail of the group’s operations, it’s success relative to its competitors, and the likely future prospects of the group.

Non Executive Directors are invited to sit on the board, participate in regular board meetings and have access to details of the business, but as their name implies, are not actively involved in running the group’s operations. I believe that they are often in a better position to know whether the shares are under or overvalued, as they are more able to evaluate the market perception of the industry and the company as they have the time and distance to be able to look from above, from 20,000 feet.

What about the number of directors transacting, does share performance have any correlation there?

Yes it does, a positive one. The greater the number of executive directors transacting at any time, the worse the performance. Conversely the greater the number of non execs, the better their performance.

I’ve weighted the share performance results with the number of directors transacting. The executive directors performance deteriorates by around a further 4 percentage points, and the non execs improves by a similar amount, calculated on a ‘per director’ basis.

Is this a Surprise?

No. Non executive directors have a much better understanding of the environment in which the company operates, and also of the valuation of the company shares, as they are able to ‘stand back’ and better analyse the environment.

Executive director share signals are clouded by disposals for tax, or buying shares to qualify for the incentive scheme. But they also have their noses to the grindstone, and therefore are less able to observe what is happening around them, to both their firms competitive position but also to stock market perceptions of their company’s shares.

Director Sells

Likewise, selling by directors can be a big warning sign. Got to be said, though, that many Director sells are perfectly honest and for legitimate reasons (for example, getting old and needing retirement security, not owning a house and needing money to buy one). You can usually ask a Director why he/she sold and get a good, open and honest approach. They may even tell you they thought the share price was good!

Anyway, for Director selling to be a true warning sign, I usually look for certain types of sales, or for selling in combination with other factors.

For example:

  • Directors selling ALL their shares.
  • Directors exercising their options or warrants, then selling the shares.
  • Directors claiming they are selling ‘to satisfy demand’.
  • Directors claiming they are selling ‘for tax reasons’.

Any of these reasons sound familiar?

Beware that directors are not infallible. Sure, directors’ deals might sometimes be indicative of company prospects – but sometimes aren’t. Several years ago someone established a Unit Trust (or was it an Investment Trust?) built around director sell/buy patterns. It folded as I recall. ROK directors bought 500k shares between them 4 weeks before it went tits up.

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