Directors' trades show the inside track

Director’s transactions are no silver bullet; you can’t just mechanically follow the lead of directors and expect to make money. Like all information about a company, it needs to be picked apart and then put into the mix with all other available information. But used carefully, it can be like the chilli in your vindaloo—it might not form the meat of your analysis, but it will certainly put some fire in its belly.

No better tip-off

As the famous American investor Peter Lynch wrote in One Up on Wall Street: ‘There’s no better tip-off to the probable success of a stock than that 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. When insiders are buying, I’d bet there aren’t three companies in history that have gone bankrupt near term.’

The directors of a company are monitoring its pulse on a regular basis and no-one is better placed to judge how it is performing. Director buying is particularly notable if it comes when a stock is down in the dumps, because rather than suggesting a rosy distant future—something that relies on a director’s judgement—it simply vouches for the fact that there aren’t any skeletons in the closet—something about which a director should have direct knowledge.

For obvious reasons, the signal is all the stronger if the buying is by a director (or preferably several of them) whom you respect, and if it is of meaningful amounts.

All these factors came together in mid-2004, when Cochlear chief executive Chris Roberts spent $2.5m more than doubling his stake in the ear implant manufacturer at around $20 per share. To drum the point home, he borrowed money from Macquarie Bank to pay for most of it. You couldn’t hope for a more copper-bottomed endorsement after the stock had fallen by a third since late 2003 following a profit warning.

We were also backing the stock at those knock-down prices, and we upgraded to an outright Buy in issue 147/Mar 04 (Buy—$19.04). Roberts and our subscribers have been well rewarded for flying in the face of popular opinion, with the stock now trading at $56.

Vote of confidence

While director buying is a pretty unequivocal vote of confidence, there are a number of reasons why a director might sell, and not all of them are bad. They might be retiring, they might be wanting to diversify their investment, or they might simply need a few dollars for that new car.  As Lynch wrote: ‘If a stock had gone from $3 to $12 and nine officers were selling, I’d take notice, particularly if they were selling a majority of their shares. But in normal situations insider selling is not an automatic sign of trouble within a company.’

While it isn’t always a bad sign, director sales are never good and they can certainly provide some useful clues if they’re interpreted carefully. In the same way that buying at least suggests an absence of nasty surprises, selling—so long as it isn’t motivated by a pressing need for the cash—suggests the company isn’t about to start performing way ahead of what the share price is already factoring in. Again, the signal is all the stronger if it comes from someone you respect and they’re selling a meaningful amount of stock.

Providing support

This was the case when Great Southern Plantations founder and MD John Young collected $32.5m for selling 7m shares in the company in February last year. The move seemed to confirm the view we had put forward a couple of weeks earlier, in issue 168/Feb 05 (Take Part Profits—$4.89). We were happy to sell some stock at those prices given our string of Buy and Long Term Buy recommendations well below the $1 mark just a few years before.

On its own, Young’s share sale would not have caused us to downgrade, but it provided support for our own view that the stock price was getting ahead of itself. Interpreted carefully, there’s always something to learn from what directors are doing with their own money.

Disclosure: Staff members own shares in Macquarie Bank and Great Southern, but they don’t include the author, James Carlisle.