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What we can learn from insiders' buying and selling

Stephen Clapham outlines some unheralded ways to study directors’ dealings
January 31, 2022

One of the first things that a junior analyst learns is to keep an eye on directors’ dealings, but sometimes this is more complicated than first meets the eye.

It’s worth prefacing these remarks with the comment that although investors want company CEOs and CFOs to have skin in the game, individuals shouldn’t have all their chips in one basket. It’s perfectly reasonable for a CEO to have an element of diversification in his or her portfolio. The analyst has to try to understand how much is acceptable and when a stock sale is more than diversification and amounts to a vote of no (or reduced) confidence in the company’s future.

 

Purchases

Although sales are more often the information rich transaction, I shall start with purchases. The purchase of a small amount of stock by an incoming chairman or CEO is usually pretty meaningless – they haven’t been at the company long enough to have a properly informed view. Similarly, I tend to place limited emphasis on the purchase of stocks by non-executive directors – they can be pressured by fellow board members directly or indirectly to 'join in' or they may simply have been sold on an idea by an enthusiastic CEO – they may not have great insight.

Obviously, the larger the purchase, the more the odds are in your favour, but I think the timing is also critical. I stress that I have not studied any data on this and these are simply personal observations, often from following directors and losing money. I tend to be more sceptical about the purchase of a stock which has suffered a recent price fall – an insider’s reaction to a short sharp price fall after a profit warning is potentially misleading; but even a purchase after an extended period of underperformance may not lead to a turn in the stock.

I accord a higher weight to a purchase if it is accompanied by some change in the external environment. When I was a hedge fund analyst, I would ask a CEO why he had bought stock and if he or she responded that competitor X had decided to:

  • Put up prices, or
  • Close a plant, or
  • Discontinue a product line,

then I would be much more interested in the transaction and the stock than if I were told that the rating or price had become attractive. Yes, a good CEO will know the value of their own business but they are not all good (or reliable) in this respect. Hence, purchases after a share price fall, short or prolonged, have to be accompanied by a good story to convince me of the stock’s merits. And I am deeply sceptical if it’s after a short price fall. All the old favourite sayings – picking bottoms, profit warnings come in threes etc – come to mind.

Rather than purchases after a fall, I am much more enthusiastic about a CEO buying his own stock AFTER it has risen 30, 40, 50 per cent or even more. This is especially true if it is accompanied by a story of some change in the business or industry. Again, I have no data to suggest that this is a winning strategy. But it’s a psychological assessment – it’s much harder to buy a stock after it has gone up, especially for an amateur and insider. Hence, my reasoning is that if a CEO buys a big slug of stock after the share price has risen significantly, then (s)he has some reason to expect that the price rise will continue – (s)he is not making a bet that the stock will bounce from a fall. 

In most cases, numbers add weight – if the CEO and CFO are dealing the same way around the same time, that is a greater comfort. I know that sometimes this can be a concerted action to arrest a share price fall, but as I have already pointed out, I place less weight on such purchases. If a CEO’s purchase is accompanied by one from the marketing director and a new product or channel is being introduced, I get more interested. Similarly, if there is a technical director or chief information officer buying stock on the back of a new product initiative – they are expressing confidence in their own expert domain and that’s generally what I am seeking to capitalise on.

The size of the deal has to be evaluated in the light of what you know about their own circumstances. The numbers might sound large in absolute terms, but not if they are on an extremely generous package, as executives often seem to be these days. Obviously, it’s hard to gauge an individual’s wealth and hence their confidence and commitment, but age is certainly an indicator, as older CEOs will have had more time to accumulate wealth.

I also try to put the transaction into the context of the individual’s existing shareholding and potential option vesting. If they already have a large holding and a large number of options, then a further sizeable purchase hopefully denotes real conviction, although there is always the risk that the director has a high risk tolerance, is over-confident, or is hoping that they can turn around sentiment. Such transactions need more careful examination.

 

Sales

If purchases can be a double-edged sword, sales are a one way bet – the individual prefers to hold cash or an alternative asset to his or her shares and that denotes a real potential risk. As I mentioned at the start, it’s reasonable for managers to have an element of diversification and it’s important not to let that cloud your judgment.

The best example of this was Michael O’Leary, CEO of Ryanair, who used to sell a certain percentage of his holding each year. I remember asking him where he reinvested the money, thinking that he had some smart angle and being disappointed when he told me that he chose gilts (government bonds). He felt that he had enough equity risk and of course he did pretty well from holding bonds over the last 20 years. I wish more managers would follow a structured policy like this – it’s sensible from their perspective as they are averaging out over time and diversifying their portfolio and it means investors know what to expect.

Otherwise, where a CEO sells a large chunk of his or her holding, it’s incumbent on the investor to inquire as to the reason and such conversations can become quite awkward. If the manager has sold because he or she thinks the shares are stupidly overvalued, it’s highly unusual for them to say so. An exception was the refreshingly candid co-founder and former CEO of Aberdeen Asset Management, Martin Gilbert, who wasn’t scared of saying he thought his shares were too dear. He was usually right. Sadly such candour is pretty rare in boardrooms today.

It’s always worth looking back over past transactions – some CEOs are really good at trading their own stock (Mike Ashley of Sports Direct, now Frasers, comes to mind), but others are less reliable indicators. I know the disclaimer says past performance is no guide to the future, but I weight the past performance when evaluating a director’s sale (and when evaluating a fund’s performance).

Most jurisdictions have pretty good rules on disclosure of director dealings, and it simply requires monitoring the UK RNS or US SEC filings. One weakness which concerns me is where directors have borrowed against their holdings. Securities backed lending is big business for the banks and disclosure standards vary widely. In the UK, if a director has borrowed against their stock and have pledged the stock as collateral, this is disclosed. This is normal in many markets, but I believe there are a number of markets where it is not compulsory – there have been proposals to introduce tighter disclosure requirements in Australia, while in Germany the rules are looser.

I am not one for creating more rules but this is an extremely sensitive area. Where a CEO has pledged stock and borrowed and the share price has fallen, he may face a margin call which he may be unable to meet, especially if the price has fallen sharply and/or a significant amount has been pledged. In such circumstances, the CEO will be under pressure to get the share price up, and that is extremely important information for investors.  

The problem is that it may not be obvious, even in the UK. Consider the situation where the CEO pledged stock five years ago and the company made all the requisite regulatory filings. But five years later, it might not be readily apparent to many owners of the shares, particularly retail investors. In a situation where the share price falls after a profit warning and the CEO faces pressure to arrest the fall or otherwise face significant personal financial loss, I think it would be helpful for this information to be widely available. Obviously, there are personal privacy constraints on what should be disclosed, but then again if a CEO or company director wants to leverage up their shareholding in the company, surely investors generally have a right to know.

 

Conclusion

Directors’ dealings is an interesting area and as I said these are simply my personal observations. But I intend to review the academic literature and see if any studies have been done which might be a helpful guide as to how to weight the information – I shall report back.