When directors buy or sell shares in their company, most people believe they are sending a strong signal to the market about the firm’s prospects. But how strong is the correlation between director trades and share price movements? And should you buy or sell because a director has too? We did some research to get closer to the truth.
One of the things equity markets take an interest in is the buying or selling of shares by company directors. It seems reasonable to think that company directors have better insight than the rest of us into the performance and prospects of a business, and that they may be more willing to buy when they see a rosy outlook, and sell when the outlook is dim.
Of course, regulation and governance should greatly limit the extent to which company insiders take advantage of their privileged position, but one suspects that these constraints may mitigate against the application of insider insight, rather than completely eliminate it.
This discussion has become more topical recently, with some high-profile examples of director selling that now look to be fairly prescient. These include cases like Aconex, Sirtex, Bellamys, Vocus, Brambles and Healthscope, where directors managed to sell shares ahead of falling prices.
There’s no doubt that director sales have been telling in these recent examples, but there is a strong tendency for investors to extrapolate from limited recent experience, and it’s always good to be a little wary of this. A better approach, we think, is to look at what the data says over a reasonable time period to try to gauge objectively how much comfort we can draw from insider purchases, and how much concern we should feel when they sell.
Academic research can help shed some light on this, but unfortunately the evidence has tended to be a bit mixed. Some studies have shown that trades by company insiders contain information, but others find little effect, and to our knowledge, good research evidence for the Australian market is lacking.
To try to better equip ourselves to deal with the issue, we did some research on ASX director trades to see if we could gain some insight into the strength of the message that these trades convey. Our work here is not of the quality that you might expect from published academic research, but should offer deeper insight than the recent anecdotes.
What we did was this:
- We downloaded the pdfs of ASX300 company announcements made over the past 8 years where the title of the announcement indicated a “change in director’s interest” or “Appendix 3Y” (but excluded initial and final director’s interest notices);
- We scanned the text of these announcements and used some rules to identify cases where the “Nature of change” section indicated an on-market trade, and exclude cases where the change appeared to result from an issue of shares under company incentive plans and the like.
- We used some further rules to extract numbers from the “Interest Acquired”, “Interest Disposed” and “Value/Consideration” sections of the announcements. For announcements that follow a conventional format these rules should work fairly well, although it’s worth noting that we will have missed some trades, particularly those where several trades are disclosed in a single announcement, and where pdf quality was not good enough for our software to extract the text. Nonetheless, we should have gotten a representative sample of the most recent 8 years of ASX data.
- In organising the data, we looked back 6 months (ie. considered director trades made in the 6 months prior to our observation date) and examined risk adjusted returns over the subsequent 3 months.
What we found was this:
- Director selling appears to contain more information than director buying. This is consistent with some of the academic research we have seen, which indicates selling is a more powerful signal than buying.
- On average, we found that around 20% of companies had one or more director share sales occurring in any given 6 month look-back period. Interestingly, the most recent data shows a relatively high proportion of director selling, which could indicate a general perception by directors that prices currently are at elevated levels.
- Also, somewhat Interestingly, there appears to be some seasonality to director selling. The peaks we see in January indicate that the second half of the calendar year – and the final quarter in particular – is the most popular time to sell.
- Because we observe director sales occurring in only a relatively small proportion of our universe (c20%), we need to keep the returns analysis simple. We divide our companies into two groups: those where no director sales have been identified in the past 6 months, and those where at least one director sale has been found. We form equal-weighted portfolios from these two groups and rebalance every three months.
- As a general rule, the companies where directors had sold shares tended to perform worse than companies where no director sales had occurred. On average the difference between the two groups seems to run to a couple of percentage points per year, but the pattern is far from consistent. Most of the performance differential occurred between mid-2009 and late-2012. In recent years, we have seen only a small differential (although the final quarter of 2016 was a good time to avoid companies with director sales)
We conclude from this that when company directors sell shares, that is not necessarily an overwhelming signal that others should follow suit. However, it clearly should be considered as part of the analysis. As is often the case, common sense should probably prevail. When you see directors selling shares in a company you own that should probably prompt you to:
- Consider the specific circumstances of the sale, and whether it may be motivated by a negative view on firm prospects or something more benign;
- Think about whether the relevant director has a large information advantage and is much better placed than you to gauge long term value; and
- Reflect on your valuation assumptions and importantly, your level of conviction in them.
Tim is the Portfolio Manager of The Montgomery Fund – a concentrated, All-cap Australian equity fund that aims to generate capital growth and income. Montgomery focuses on owning high quality businesses and generating superior returns.