This article appeared in the May 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
Can you boost returns by watching what company directors buy and sell?
By Michael Kemp, author
Investors today have access to more information than ever before, but a core source remains the annual and semi-annual reports produced by the companies themselves. In interpreting them and forming a view of a company’s prospects, investors often look to comments by the directors.
In evaluating these judgements it would be prudent to recall the words of the 17th Century philosopher, John Locke, who said: “I have always thought the actions of men the best interpreters of their thoughts.” Or in the common vernacular: “Actions speak louder than words.”
With this in mind, some financial analysts like to observe the dealings undertaken by directors in the shares of the company they manage. Intuitively this would seem to make sense, given directors’ intimate knowledge of the operations of the business.
This concept was enthusiastically embraced by US fund manager Peter Lynch when he said: “There’s no better tip-off to the probable success of a stock than when people in the company are putting their own money into it … When insiders are buying like crazy, you can be certain that, at a minimum, the company will not go bankrupt in the next six months.”
Termed “director dealings”, they should be distinguished from the illegal practice of insider trading that seeks to profit from the use of confidential information. This article explores whether following these trades provides useful information for the share investor.
New ASX listing rules governing director dealings
The Australian Securities and Investments Commission (ASIC) and the Australian Securities Exchange (ASX) govern the trading activities of company directors. Until this year the securities trading policies of ASX were covered by non-mandatory corporate governance recommendations.
On January 1, new ASX listing rules covering the policies applicable to this activity came into effect. All listed entities are now required to define and disclose a Securities Trading Policy that complies with the minimum content requirements spelt out in ASX Listing Rule 12.2. Rather than being prescriptive, the new rules require the company itself to define the trading limitations that are most appropriate to its own circumstances.
Companies are now required to define closed or black-out periods when directors are prohibited from trading in the company’s securities. These are typically the times between the closing of the company’s books and the public disclosure of its financial results. However, any period, if seen as appropriate, can be specified by the company.
Where to find the information
Both the Corporations Act (2001) and ASX Listing Rules require full disclosure of the trades made by directors in the securities of their own companies. ASX Listing Rule 3.19A provides that a listed entity must advise ASX of any notifiable interest of a director no more than five days after the date of a change in the director’s interest.
This information is made available to the public in the company announcements section of the ASX website. Specific director dealings are disclosed under the title “Change of Director’s Interest Notice”. Another source of this information is The Australian Investor Information Service website. Both sources provide raw data that requires interpretation. Some investment newsletters and websites collate and interpret this information for their subscribers. Examples are the Intelligent Investor and Business Spectator newsletters.
How to interpret the information
Director dealings should not be used by investors as a mechanical buy or sell signal. The information needs to be interpreted within a wider analytical framework. To assist in this it may be useful to consider the following:
- Share purchases made by a director with their own money should send a stronger signal than allocations through executive share schemes or the exercise of company granted options. The ASX notice will indicate this. An even stronger indication is if the shares have been purchased with borrowed money, but this information is less readily available.
- Buying carries a stronger message that selling. To quote Peter Lynch again: “There is only one reason that directors buy: they think the stock price is undervalued and will eventually go up.”
- In analysing selling, look for the pattern of selling. Although buying is undertaken with a profit motive, selling can be undertaken for a variety of reasons. The sale of a sizeable parcel of securities by a single director might not indicate much in itself. A share sale might be made to diversify holdings, finance a new house, settle a divorce, pay down debt, or fund retirement. Looking at the pattern of selling can assist in differentiating between financial and non-financial motives. For example repeated selling by several directors sends a stronger signal than an isolated sale.
- It is also useful to compare the size of the trades in relation to the size of each existing holding and whether it is the directors at the core of the business, such as the CEO, who are undertaking the trading.
- Consider the trades in relation to recent movements in the share price. Has the share price been falling? Value investors are constantly on the lookout for “fallen angels” – previously well-regarded companies, in particular those that have become undervalued as a result of the price fall. Under these circumstances, the signal given by directors buying or selling might provide additional information in determining whether value is on offer or if the fall is justified.
The important question is whether this is all proposition or whether an observation of director dealings does actually provide useful information. Who is to say that a director’s judgement is superior? Researchers have investigated this question.
A British research company, Director Deals, undertook a study of returns achieved based on directors’ transactions between 1999 and 2003. They found that significant buying by directors was followed by an average rise of 23.5 per cent in the year after the purchase, and significant selling was followed by an average fall of 15.5 per cent.
European Business School academics Dardas and Guttler analysed short-term announcement effects on 2782 companies in eight European countries between 2003 and 2009. In keeping with the intuitive hypotheses proposed in this article, they found the magnitude of the announcement effect depended upon the transaction size, and that it was more significant if there were multiple trades by different directors on the same trading day. They also found the results were stronger for purchases than sales and that the corporate position of the director was positively correlated to the size of the announcement effect.
Take care with the data
A study of director dealings should not be used as the sole basis for making investment decisions. They represent but one piece of information and must be interpreted within the context of all available information. They are not a substitute for a full analysis of a company’s fundamentals. This issue is addressed in ASX Guidance Note 22, which states: “ASX does not believe that directors’ securities trading is necessarily an indicator of an entity’s prospects, and discourages any perception that investors should rely on such information in making investment decisions.”
About the author
Michael Kemp has had a long career in Australian financial markets. Following the release of his first book, Creating Real Wealth, in 2010, he now works as a freelance financial writer.
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