Director purchases are worth watching

You might think directors' share sales spell trouble. Not necessarily. And purchases are even more important.

Market observers keenly follow directors' transactions - the practice of a board member buying or selling shares in the company on whose board they sit.

The reasons for this are obvious: a director is likely to know more about the company for which they work than any analyst or investor. But it's not quite that simple, as this examination of the subject will indicate.

Imagine you're a company director with a 9% stake in a successful, growing business. The company has just reported an interim profit of $8.8m, more than double its interim profit of three years ago.

Strange

But over that period something strange has occurred. Three years ago nobody was particularly interested in your stock.

Now people are clamouring to acquire it, at a price five times higher than before, despite profits only doubling. What do you do?

You might sell part of your shareholding, as Walter Pahor, then managing director of 'green' energy business Energy Developments , did in May 2001. When faced with similar circumstances he sold 2m shares, reducing his stake to just over 5%. It didn't go down too well.

Indeed, when Matthew Perrin, the former managing director of Billabong International sold 8m shares last year, it cost him his job. Was 'the market' right to judge these two cases as warning signs of bad news to come?

Well, shares in Energy Developments have since fallen by about 80% and Pahor's timing looks most fortuitous. And Billabong is down more than 20% since Perrin bailed out of the surfwear company. So, at first glance, the presumption that directors selling is a warning sign rings true.

Why they sell

By itself, though, it is not necessarily cause for alarm. Investment guru Peter Lynch, author of One Up On Wall Street , says there are many reasons why directors sell.

They may need money to buy a new house, pay off a debt, or simply want to diversify their investments - this last reason was used by Pahor to justify his sale.

That's true. Directors, just like ordinary investors, may have very valid personal reasons for selling down their stake. At Intelligent Investor we tend to look for some additional information to help us interpret the sales. Here are some warning signs to watch out for:

Be wary of director sales if the stock is expensive. Energy Developments and Billabong were extremely 'popular' stocks that had already risen substantially before director sales. Energy Developments had also taken advantage of its share price strength to raise $105m in new capital shortly before Pahor dumped stock.

Watch out for repeated selling by several directors. Ongoing sales by more than one individual suggest the future is less rosy than ordinary shareholders might expect. Where more than one director is selling, the case for getting out strengthens.

Beware of share sales associated with the departure of a managing director or chief financial officer. It may not surprise you to learn that Pahor had already announced his resignation as managing director prior to his decision to offload stock.

So what about director buying?

Well, Peter Lynch says it best - 'There's only one reason that directors buy: They think the stock price is undervalued and will eventually go up'. This is an important distinction. Directors sell for all sorts of reasons but they buy because they expect to make money.

So take note when respected directors buy with their ears pinned back, particularly if they already hold large stakes. Gerry Harvey of Harvey Norman is a case in point.

In issue 124/Apr 03 (Buy - $2.02) we mentioned that he bought 2m shares at prices below $2.00 - when war hysteria was at its peak - and we were happy to back his judgment by calling the stock a buy. Remember that this is the same Gerry Harvey who sold stock in July 2001 at more than $4.00.

Legal disclosure

By law, all directors have to disclose to the ASX transactions within five business days of them occurring. Directors that use their own cash to purchase shares, rather than options exercises and the like, are the ones to really watch out for.

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