‘There are many reasons insiders sell, but only one reason they buy.’ The old Wall Street adage is another way of saying that share dealing by directors is worth keeping a close eye on. They can send powerful signals to the stock market; yet it can often take days or weeks for most investors to latch on to the news of buying or selling, giving the savvy investor an advantage by making this a priority place to monitor.

Directors should know better than anyone else the true value of the businesses they run. Academics, investors and our own research indicate following smart money can be a successful strategy. Here we look at how investors can seek out the most profitable opportunities.

PROFITABILITY

Academic research points to better investment returns in stocks where there is heavy director dealing - and not just on the day the purchase is made.

This is at odds with financial theory, which assumes all available information is incorporated into a stock price when announcements are released.

Constructing a ‘rolling purchase portfolio’ which contains all of the stocks which have been purchased by directors in a 12-month period, Boston University academic Leslie A. Jeng found monthly returns were around 40 basis points (0.4%) better than the market, or around 5% a year, for 12 months after an announcement.

Jeng’s research, published in 1999, was based on a sample of director dealings between 1975 and 1996 in the US. The results are based on buying shares at the end of the day a director bought shares. Purchases by directors showed positive future ‘abnormal’ returns - this means returns adjusted for risk - while director sale transactions showed no significant return pattern, positive or negative.

More recently, a 2008 report Some Insiders Are Indeed Smart Investors finds a 2.9% excess return over a 120 day time horizon from when director share dealing was announced to the market. That translates to a 6.1% abnormal return on an annualised basis, assuming 250 trading days per year.

Based on UK stock market director dealing between 1994 and 2006, the academic researchers found portfolios could be created ‘that generated an economically and statistically significant return’.

‘In particular, immediately after a directors’ purchase announcement, we find that shares tend to outperform the market by 0.7%,’ says the report, which also included research from bankers at Citigroup.

‘We also find that stocks outperform by 1.2% between days one to 60 and by 2.9% between days 1 and 120. Other academic performance points to better excess returns for director dealings in smaller companies.

INVESTORS

Never mind the theory - what about those who are active in the market? Investors should take notice of director holdings and recent transactions, according to private investor Lord Lee of Trafford.

Lord Lee, whose book How to Make a Million - Slowly is based on a lifetime of investing in stock markets, says management sales of stock were a key reason he recently exited a position in convenience retailer McColl’s (MCLS).

Year-to-date, directors at the Brentwood, Essex-based business have sold a total of £735,000 worth of stock at today’s prices.

Part of Lord Lee’s investment approach is to identify listed firms with heavy insider ownership and long-term shareholders.

‘Essentially, to me, I will not invest in a company - or very rarely - unless the directors who are running it have significant investments in the business. And not in the form of options but committed shareholdings,’ Lord Lee explains.

‘Parallel to that, I have focused over the years and have benefited from investing in what I call “proprietorial” companies where there is a family shareholder base or a controlling position.

‘The reason for that is... there is the old saying from clogs to clogs in three generations... but there are a number of family businesses that have survived and prospered and the emphasis is on stewardship, which is an idea I’m very keen on.

‘The new generations running the business typically are very conscious of its history and the responsibility they have to future generations and shareholders to adopt a conservative approach to running the business they are in charge of. They are not taking risks, or betting the family silver on reckless pursuits.’

Examples of companies with heavy insider ownership within Lord Lee’s portfolio are consumer goods specialist PZ Cussons (PZC) and Nichols (NICL:AIM), owner of soft drinks brands Vimto, Sunkist and Panda.

Private investors are reasonably switched on to this idea, according to Phil Oakley at data platform Sharescope. Director deals are a popular feature on its new browser and tablet-enabled application, SharePad.

‘I think the main thing is that investors get a lot of comfort from knowing the companies’ directors and management have a stake,’ he says. ‘For most, before taking a decision to buy shares, investors want to know how much key management already own - it’s often referred to as management being willing to eat their own cooking.

‘Even in the FTSE 100, it’s not uncommon to find managers that own hardly any shares at all and some only own the ones they have because of share option awards.’

Tracking movement

A neat feature on SharePad is the ability to see the relative change in director holdings at individual companies in UK markets over a period of three months.

This can be a valuable tool in determining where meaningful director dealings are taking place, though some must be taken with a pinch of salt.

At the top of the list, Exova (EXO) directors were awarded substantial share option awards under long term incentive plan remuneration. The options are not exercisable until performance conditions have been met.

Other stocks high up the list have been skewed by changes in shareholdings as a result of initial public offerings (IPOs), for example at Curtis Banks (CBP:AIM), Gear4music (G4M:AIM), Fishing Republic (FISH:AIM), Adgorithms (ADGO:AIM), Mayair (MAYA:AIM) and Verseon (VSN:AIM).

Among the more meaningful moves in the FTSE 350 over the past three months is director buying at Telecom Plus (TEP), with a 12% increase in the holding of chairman Lord Wigoder to 13 million shares, valued at £104 million. The £375,000 deal was covered by Shares (Director Dealings, 23 Apr) immediately after the event - an example of how we strive to keep readers abreast of the most significant director transactions.

Director dealings dating back decades also feature on the SharePad platform. Investors can scrutinise which managers have the best track record on buying and selling shares at different stages of the economic cycle.

Robert Walters, chief executive and founder of recruiter Robert Walters (RWA), was once dubbed ‘Bobby Dazzler’ by The Times for the timing of his share transactions ahead of improving and deteriorating economic conditions.

Another director we found to have a good trading record is chief executive of British Polythene Industries (BPI) John Langlands. You can see Langlands’ purchases and sales in the accompanying chart. Sales of stock can be for many reasons but Langland so far seems like he has a good record of spotting when BPI looks undervalued.

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Reasons to read Shares

Director dealings in stocks covered by Shares have tended to indicate better future performance among companies with sub-£500 million market capitalisations.

Out of 20 director ‘buys’ covered by Shares between 2 February 2013 and 14 November 2013 - the earliest we have available on our website - the average return to date was 71.4%. That compares to an average gain of 20.3% for the benchmark.

It’s important to note that a lot of the gains were concentrated in one stock, Daniel Stewart Securities (DAN:AIM).

The shares have been rallying strongly after former Quindell (QPP:AIM) founder Rob Terry declared a 7.4% stake in the business. Executive chairman Peter Shea bought around £64,000 worth of shares in the business on 10 Oct 2013 and now sits on a 794% profit. Removing that transaction gives an average of 33.4% versus 20.5% for the benchmark.

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Longer-term approach

The average length of the returns we tracked, which are from the date published in Shares to 17 June 2015 is just under two years.

Tracking the returns over a longer time period makes more sense to us because directors are unlikely to frequently trade in and out of their own stock in large volume.

Large, significant transactions by directors are most likely when they see a wide gap between market value and their estimate of intrinsic value - though they may not always be right.

Annualising the average returns for the director deals gives a number of 25.1% (FTSE Small Cap: 10.4%) including the Daniel Stewart transaction and 12.3% (FTSE Small Cap: 10.4%) without.

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Out of the 26 small cap transactions across the period, six were sells. Interestingly, contrary to most academic literature, our results showed stocks with heavy director selling performed significantly worse than the market.

Academic literature indicates there is generally no performance difference in stocks where a director makes a large sale. Director stock disposals are, according to the research, more likely to be seen by the market as a reflection of the individual director’s personal financial requirements, rather than containing any negative information about the business.

For our data set the average return for stocks after director ‘sell’ transactions was 6.5% over the full, roughly two-year period versus 21% for the FTSE Small Cap.

It’s important to note our calculations are rough-and-ready and the sample is small - though we did check all the total returns information against Thomson Reuters Datastream, which adjusts for dividends, splits, consolidations and equity raises.

The results are also not statistically significant. The largest gain is 794% and the biggest loss 59%, meaning the variance across the sample is very large. In theory, financial markets should price in all information into prices as it occurs. In practice, there’s plenty of evidence to show the reaction to director dealings is not always immediate, so anyone spotting a big share transaction by a director could have time to take a position before the masses cotton on to the news.