One of the first things that a junior analyst learns is to keep an eye on directors dealing in their companies’ shares, but sometimes this is more complicated than you might expect. In this article, I look at some less obvious ways to study directors’ deals.
Although investors want chief executives and chief financial officers to have skin in the game, individuals shouldn’t have all their chips in one basket. It’s perfectly reasonable for CEOs to have an element of diversification in their portfolios. The analyst has to try to understand how much is enough – and when a stock sale amounts to a vote of no (or reduced) confidence in the company’s future.
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 if you follow the director, but 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 working at hedge funds, I would ask CEOs why they had bought stock and if they 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, good CEOs will know the value of their own businesses, 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 sayings about picking bottoms and profit warnings come in threes – come to mind.
Rather than purchases made after a fall, I am much more enthusiastic about a CEO buying stock AFTER it has risen 30%, 40%, 50% 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, they have some reason to expect that the price rise will continue – they are not making a bet that the stock will bounce from a fall.
In most cases, numbers add weight – if CEOs and CFOs 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 by 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, then they are expressing confidence in their own expert domain – 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 a factor, as older CEOs will have had more time to accumulate wealth. I therefore always like to check the executive’s age.
I also try to put the transaction into the context of the individual’s existing shareholding and potential options vesting. If they already have a large holding and many options, then a further sizeable purchase hopefully denotes real conviction, although there is always the possibility that the director has a tolerance for high risk, is over-confident, or is hoping that they can turn round sentiment. Such transactions need careful examination.
If purchases can be a double-edged sword, sales are generally a one-way bet – the individuals prefer to hold cash or an alternative asset to their shares and that denotes a 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 re-invested 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 past 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 portfolios – and it means investors know what to expect.
Otherwise, when a CEO sells a large chunk of their holding, it’s incumbent on the investor to ask why, and such conversations can become quite awkward. If the manager has sold because they think 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.
Directors’ dealings is an interesting area and these are simply my personal observations. In a later post, I shall review the academic literature to seek empirical evidence on how to weight the information.