Not all directors' deals are created equal. That at least is the finding of the quant team at Standard Life Investors and something that was highlighted by the company's star small-cap manager, Harry Nimmo, when he outlined some of his favourite tools for stockpicking to IC readers in our "Big profits from small companies" cover feature late last year (we also republished his comments on our blog last week).
It's not only the size of purchases that the Standard Life team has found matters. The size of the company is a big factor, too, in determining the predictive power of directors' purchases and sales; it is significant for smaller companies, but not so much for big ones. It also matters who is buying or selling - the closer to the coal face the better. And it helps if the dealing activity chimes with the sentiment towards the stock in question - directors buying a stock that's popular with the market is good, while directors selling falling shares can often be the proverbial rats deserting a sinking ship.
In Mr Nimmo's own words: "We've found that for large-caps director dealings are not predictive of price movements. In small-caps director dealings are predictive, but not as predictive as they once were. I think they have become less predictive due to increased scrutiny by regulators. "We look for directors buying and selling and price momentum together. Big signals are buys into rising share prices and selling into falling share prices... If the share price is going up, it is fair enough for a director to take profits. Selling on the way up tells us much less than when directors are taking money out when the share price is significantly down. Similarly, you often see a series of directors buying together after a profit warning when the shares are significantly down - that's normally just PR noise... "We look for the chief executive, the finance director or other directors who are operationally involved. We also look for a clustering of deals... A first purchase is less significant, especially if it is made by a non-exec, as directors tend to be under pressure to make a show of faith." |
Mr Nimmo is far from unusual in seeing directors' dealings as being something that work best when used in a wider context. Other famous investors that have been big fans of top brass that put their money where their mouths are include Jim Slater and Fidelity Investments fund management legend Peter Lynch. But both these guru investors looked at director dealings as part of a wider analysis of stocks rather than as a firm signal to buy or sell in isolation. However, what's particularly enticing for me about the results from the research undertaken by Mr Nimmo and his team is that it provides a very 'screenable' perspective on this very interesting subject.
That said, one big issue any director-dealing screen runs up against is the quality of data on trades. My screen is based on the director deals reported by this magazine's website for the month of September. Trawling the associated regulatory news service (RNS) announcements for details of the deals reveals that some are exceedingly complex and often occurred for largely technical reasons. Fortunately many are also the kind of straightforward purchases or sales that are of real interest. So this week, rather than slickly importing data into a spreadsheet and then throwing excel formulas at it, I've had to scour the director dealings announcements to manually separate the wheat from the chaff.
The screen looks for director buying in companies that appear to have decent prospects based on share price momentum and/or broker forecast upgrades. It also focuses on smaller companies. The screen's tests are:
■ Market cap under £1bn. ■ Director purchases totalling £50,000 or more during September 2016, suggesting an amount of money that may be of some significance even to the UK's lavishly paid executives. The directors buying must include those with operational control. ■ Positive share price performance over the past three months. ■ Earnings upgrades over the past year and/or past three months. |
While four stocks passed all the tests, the purchase of shares in Adept Telecom looks of limited interest based on the fact that it has been made by a recently appointed chief executive and therefore looks like the type of show-of-faith purchase Mr Nimmo thinks investors should pay less attention to. That said, Adept's strategy of acquisitive growth in the fragmented telecoms services market has been serving its shareholders well, as have efforts to increase the proportion of sales from its higher-margin managed services operations (now 44 per cent of the total, up from 27 per cent in the 2014-15 financial year). A faster-than-expected drop-off in net debt since its £7m purchase of Centrix last year also leaves scope for more deals.
Fundamentals relating to Adept appear in the table below as do details of the other three stocks that passed all the screen's tests, which I've also provided write-ups for.
The director deals to watch
| Name | TIDM | Market cap | P | Fwd NTM PE | Dividend yield | Fwd EPS grth FY+1 | Fwd EPS grth FY+2 | 3-mth mom | Net Cash/Debt (-) | 12-mth upgrade to Fwd EPS FY+1 | Director (s) buying | Shars | Av. price | Value |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Character | AIM: CCT | £100m | 473p | 11 | 3.0% | 1.1% | 7.9% | 2.4% | £15m | 11.9% | FD (10k), non-exec (4.6k) | 15k | 435p | £63k |
| McBride | LSE: MCB | £339m | 186p | 14 | 1.9% | 19% | 10% | 20% | -£91m | 10.3% | CEO (10k), FD (10k), non-exec (10k) | 30k | 175p | £53k |
| Craneware | AIM: CRW | £343m | 1,278p | 36 | 1.4% | 7.8% | 8.2% | 36% | $49m | 1.8% | CEO | 5.4k | 1,200p | £65k |
| AdEPT Tele. | AIM: ADT | £53m | 235p | 11 | 3.0% | 18% | -0.8% | 1.9% | -£6m | 21.5% | Comms director | 85k | 235p | £200k |
*Based on 3 months, downgrades over 12 months
Source: Companies' RNS, Bloomberg, S&P CapitalIQ
Craneware
Shares in hospital software developer Craneware (CRW) have been on a tear over the past three months and, while the modest level of earnings upgrades over the past year don't point to anything that great, recent results for the year to the end of June suggest that could soon change. Changing regulation in the US healthcare market is adding to the already byzantine complexity experienced by both doctors and patients. As such, Craneware's mission to provide software that can improve both clinical and financial outcomes looks particularly relevant.
Just as importantly, this positive market backdrop is feeding through to the company's performance. In the recent financial year new orders rocketed by 63 per cent and existing customers continued to show their willingness to pay more for Craneware's services, with the value of renewal work running at over 100 per cent.
The company is also investing in broadening its software's capabilities and moving to cloud-based solutions, which it is hoped will underpin order growth. The operation of a subscription model also makes the company a reliable revenue generator - especially given the impressive renewal rates - and both the net cash position and cash conversion look impressive.
But while Craneware's shares do have a lot going for them based on the group's progress and prospects, their eye-watering valuation demands a show of faith by new investors. As such, director buying can be regarded as reassuring, especially as it is coupled with strong share price momentum and the distinct possibility that brokers will find reason to upgrade forecasts in the not too distant future (last IC view: Hold, 1,045p, 6 Sep 2016).
McBride
The show of faith by McBride's (MCB) management can be seen in light of the turnaround that is under way at the group. The appointment in 2014 of turnaround specialist Rik De Vos saw the own-label personal and household goods manufacturer set out a plan to revive its ailing fortunes. Initially the focus has been on reviving operating margins with an ultimate aim of getting them to 7.5 per cent by 2020, or possibly sooner. In the year to the end of June 2016 there was good progress on this front, with the profitability measure increasing from 4 per cent to 5.4 per cent.
Among the initiatives the company has undertaken is a cull of three-quarters of its customers who together accounted for just 3 per cent of sales. The reduced complexity has helped McBride focus on improving efficiency and cutting £12m of costs. The company, which has a huge annual bill for input costs, has also been attempting to use its scale to improve its buying.
With the first phase of the turnaround now drawing to a close, the focus is switching to investing in the company's operations to make it more efficient and to put it in a better position to bid for new work while maintaining profitability. Management's goal is that efficiency improvements along with the margin gains will result in a sustainable return on capital employed of 25-30 per cent.
The post-referendum weakness of sterling is an issue for McBride because it has a lot of dollar and euro-based costs but generates a third of its household sales in the UK (the company does not give a geographic breakdown of personal care sales, which account for just over a fifth of the total). It also has considerable sales exposure to Europe, which means concerns about the economic ramifications of Brexit are a cause for uncertainty.
Debts are also on the high side, especially considering the £31m defined-benefit pension scheme deficit. That said, management reckons borrowings will continue to fall even while the company makes about £100m of investment in the business over four years. What's more, the turnaround plan is going well and there should still be plenty of scope for sales and profits to improve as a result of a recovery. Importantly, the shares' relatively modest rating suggests there should be plenty of upside if the turnaround plan continues to deliver, as the company does not command the type of bumper 'recovery' multiple investors are used to paying for the market's most popular comeback stories - think of Tesco priced at 22 times next 12-month consensus forecast earnings, for example (last IC view: Buy, 171p, 8 Sep 2016).
Character Group
While shares in toy wholesaler and recent IC tip Character (CCT) are up on the past three months, this reflects a rebound following a post-referendum savaging. The market's concern is that the group will suffer due to the fact that it outsources manufacturing to China, which means most of its costs are incurred in dollars. And despite considerable overseas growth in recent years, three-quarters of sales are in the UK, which means there is a painful currency mismatch in prospect even though hedging should help delay the hit for a while.
Another Brexit-related fear revolves round the fact that the toy market is very sensitive to the broader health of the economy, so any slowdown would hurt. That said, the market seems to be becoming more relaxed on this front and the international toy market has been in rude health. Perceptions of the quality of Character's business are not helped by the fact that it licences the characters it makes into toys rather than being in the more powerful position of owning its own brands. That said, it has proved good at winning and holding on to work over the years, having made Peppa Pig toys for 12 years and recently winning the Stretch Armstrong master licence from Hasbro, among others.
It's not only the directors that are keen on Character's shares. The company has a long track record of share buybacks and over the past 10 years has reduced its number of shares outstanding by 60 per cent. Management has recently got permission to spend up to £5m until 20 January 2017 buying back up to 15 per cent of the remaining shares.
Importantly, Character's strong cash generation has ensured healthy dividend growth has accompanied the buybacks over recent years. And the case for using buybacks to enhance shareholder returns looks compelling based on the group's net cash position and its shares' lowly rating (see table), although the low rating admittedly reflects some of the inherent risks in the business model associated with cyclicality and licence negotiations (last IC view: Buy, 455p, 29 Sep 2016).
