Nobody ever sold a stock because they thought it would go up. So wrote veteran Wall Street journalist Alan Abelson. It was an astute observation and should be heeded in particular when a stock is sold by a company insider, such as a director. When directors sell their shares, it can be a powerful indicator of the company's future performance and provide investors with a valuable source of investment intelligence.
A company's directors, particularly directors in executive positions, have more insights into the business and its outlook than any other participant in the market. Because of their unique position, when they sell, it can be tantamount to a vote of no confidence in the business. As such, we are generally sceptical when directors sell, as it can signal a negative outlook for the company. This is particularly the case when a director substantially reduces their holding, or more than one board member sells simultaneously, or within a short time frame.
Change of director's interest (appendix 3Y) notices announced on a company's Australian Securities Exchange page notify investors when directors buy or sell shares in a company. As part of our investment process, we closely monitor and scrutinise these announcements when assessing a stock idea and reviewing companies already in our portfolio. We pay particular attention to sales by executive directors responsible for day-to-day operations, such as the chief executive.
Analysis this year by stockbroking firm Wilsons (not related to Wilson Asset Management) of appendix 3Y notices published in 2016 found that of companies whose management sold large parcels of shares, 76 per cent underperformed the market following the sale. Furthermore, share prices of these companies fell by an average of 14 per cent.
The research also revealed a relationship between the size of the directors' share sale and the company's performance, with the risk of underperformance increasing as the value of the parcel of shares sold increased. Critically, share sales of any value by a director holding the position of CEO, chief financial officer and/or chief operating officer were correlated to significant underperformance of the company's share price, according to the findings.
Skin in the game
As well as indicating a potentially negative outlook for the company, when directors sell, this diminishes their "skin in the game", sometimes significantly. In our investing experience, when management (including directors) are part-owners in the company they are running, the business is more likely to outperform its competitors. Management with "skin in the game" are personally exposed to the performance of the company aligning their interests with the shareholders'.
Over the last 12 to 24 months, various companies have seen their share prices collapse spectacularly following the disposal of shares by a director or directors.
Just days after giving an upbeat assessment of Brambles' outlook at the company's 2016 full-year result, the then-CEO Tom Gorman sold his entire stake in the company.
The company affirmed its profit guidance in a trading update nine weeks later and again at its November annual shareholder meeting. However, in January and again February Brambles downgraded its profit guidance, sending its share price tumbling to fresh three-year lows. At the time of writing, shares in Brambles were trading at $9.42, down 27 per cent since Mr Gorman sold his shares for between $12.79 and $12.97 a share.
In September last year, Vita Group founder and director Maxine Horne sold 10 million shares at $4.95 each, raking in a cool $49.5 million. The sale represented approximately 30 per cent of her total holding in the company and came just days after Vita Group's shares hit an all-time high of $5.35.
Over the subsequent months, Vita Group's shares drifted lower, weighed down by speculation in the press that its agreement with Telstra (which is fundamental to the company's profitability) would be adversely amended. In May, the company announced "remuneration reductions" under its Telstra licence agreement. At its recent annual meeting, Vita Group announced a $25 million annual impact from the remuneration changes with full-year 2018 earnings before interest, tax, depreciation and amortisation expected to be between $36 million and $43 million, down from $65 million in the previous corresponding period. Since Ms Horne sold her shares, Vita Group's shares have slumped 74 per cent to $1.29 a share (at the time of writing), wiping more than $500 million off the company's market value.
Exceptions to the rule
Insider sales are not necessarily an ominous sign. Directors may have a legitimate reason for selling some of their shares, such as to rebalance their investment portfolios, particularly when a company's share price has appreciated considerably.
Strong fundamentals and continued demand for its products have driven a2 Milk's share price higher over recent years. As the company's shares have increased in value, CEO Geoffrey Babidge has consistently sold parcels of shares in the company. Since Mr Babidge last sold shares in May this year, shares in a2 Milk have more than doubled in value and the company has been the best performing stock in the S&P/ASX 200 over the last 12 months.
Other possible explanations for director selling include paying tax liabilities or other expenses. When reporting the latest Domino's Pizza profit result, CEO Don Meij took the unprecedented step of announcing his intention to imminently sell a significant portion of his shares to fund financial obligations, including in relation to a matrimonial settlement.
While director sales can be a red flag, conversely, when board members increase their holding, it demonstrates their ongoing commitment to the company and can indicate a positive outlook. However, the correlation between director buying and positive performance is weaker than the correlation between director selling and negative performance.
Chris is the Chief Investment Officer of Wilson Asset Management, having joined the company in 2006. He is also the Portfolio Manager responsible for WAM Capital (ASX:WAM), WAM Research (ASX:WAX), WAM Active (ASX:WAA) and WAM MicroCap (ASX:WMI).
Very interesting article Chris. What is your view then on KGN?