As the markets stay volatile, maybe we should look at some insider trading? – where the ‘insider’ is a director of a company.
Many investors like to buy shares in companies in which the directors themselves are buying stock. The theory is simple: directors should know more about their own companies than outsiders. Therefore, if the directors are buying shares this should signal the company is doing well and that the share price will rise. And if they’re selling shares, well surely it’s time to bail out.
The internet makes tracking such directors’ dealings easier than ever – easier to get the information, easier to track purchase or sale trends, and quicker and easier to react to these signals.
In fact, there’s only one problem with this theory: it doesn’t work.
My conclusion? If directors’ dealings do work as a signal, they don’t work in an obvious, easy or straightforward way. Which is a good reasons not to use it at all.
Closer inspection reveals why directors dealings don’t work as a signal. Directors could be buying shares not because of faith in a rising share price, but because the company expects new directors to do this (just as a new worker is expected to ‘volunteer’ overtime). It could also be that the share price has fallen sharply and they’re buying stock as a public statement of confidence in the company. Equally, it could be part of their estate planning, tax re-organisation, or an exercise of options. These purchases are hardly calculated moves based on the director’s belief in a share price rise.
But although directors’ purchases are not a good signal to buy their stock, perhaps their sales are a good reason to sell it. After all, isn’t the director saying his money is better off elsewhere?
Not so. Wharton’s Andrew Metrick and Harvard’s Leslie Jeng constructed a hypothetical portfolio of all ‘insider’ (the US term for high ranking corporate officers including directors) sales over a 10-year period ending in 1996. The portfolio merely performed in line with the market. You might as well have ignored directors’ sales altogether.
And Professor Josef Lakonishok, Illinois University, came to the same conclusion when he examined directors’ share sales. He found that executives are twice as likely to sell their company’s stock as buy it, simply because many receive their pay in options. And the timing is random, too – more likely prompted by the need to raise cash to make a down payment on a new car than doubts about the company’s future share performance.
So if neither directors’ buying nor their selling is a signal for the net trader to do the same, perhaps we should do the reverse - buy when they sell and sell when they buy? Evidence for this comes from a test by Business 2.0 magazine, which found that a portfolio of 100 stocks with the most insider selling actually gained 40 percent over 12 months.
Alpesh Patel
www.alpeshpatel.com/go
