Why it pays to follow the insiders

Following insiders' leads in buying and selling decisions is a bit like Sex Panther perfume (per the movie Anchorman), 60% of the time it works every time. This was evident in our review of historical literature and in the director trades of FY2019 and FY2020. We make the following points, some of which are somewhat obvious.

• Director buying has greater information than director selling. This famous Peter Lynch quote sums it up best "insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise."
• Without detracting from the above quote, buying is sometimes undertaken by insiders to game markets and assist capital raising efforts, a phenomenon common but not limited to small cap resource companies
• The closer to the coalface the better. As the Perich family may attest, executives buying and selling is a better signal than a non-executive director, given Management should have a better understanding of the day to day operations. Some papers have even gone as far as suggesting CFO trades are more profitable than CEO trades
• Director trading as a signal is more powerful the smaller the company
• Obvious point but the more directors transacting (and obviously the more material the stake) the better the signal. We have tried to show this as a % of market cap in the tables below
• One-off opportunistic trades (i.e. one off on-market buying) is more powerful than “routine” trades. The Cohen, Malloy and Pomorski 2010 study showed this best with 0.82% abnormal monthly return vs 0% for routine trades
• Insiders can often act well in advance of good news so the phrase “stay the course” is relevant
• Stocks with high free cash flow yields that are subject to insider buying have even stronger outperformance than low free cash flow yield purchases
• There can be many false flags. Just ask any investor who got spooked because Bevan Slattery sold 10 million NXT shares in November 2014 at AUD1.95/share, or 3.3 million MP1 shares in May 2019 at AUD5.11/share

Most market participants will refer to Bloomberg for cues regarding insider trading but we have noted that the Bloomberg data doesn’t necessarily split insider dealing into on-market trades and other trades. While we can’t speak to the accuracy or completeness of the data contained in Market Index it does appear to offer greater information content than Bloomberg, albeit at the expense of extra manpower inputting data and working spreadsheets, to compile the following tables. We won’t provide a stock by stock analysis of each of these but in the subsequent paragraph we provide some examples of how Insider dealing has contributed to the Chester decision making process.

Source: Chester Asset Management with data from Market Index

Owners of capital

We will look to release a more detailed paper on executive remuneration and tenure in the coming 6 months but as noted in our opening, part of our thought process on insider dealing extends to the overall level of insider ownership.

We find that owners of capital have much stronger alignment of interests with shareholders than non-owner stewards of capital (executives without significant stakes or long tenures) which as evident in the graph below has historically translated to outperformance. Another somewhat obvious point but the smaller the company the more likely it is for founders and owners of capital to exert more influece over the direction and success of the company, hence aligning ourselves to passionate and entrenched founders / CEOs is something we pay a good deal of attention to. There are plenty of reasons why owners of capital outperform including but not limited to the culture in the company driven by the mindest of its founders to challenge industry norms and persevere. Jeff Bezos, who is probably the most famous founder of our time, also has some of the most expensive failures was once quoted as saying, "If you decide that you’re going to do only the things you know are going to work, you’re going to leave a lot of opportunity on the table".

Source: First Republic Bank

Conclusion

We would all love to be able to utter the phrase “I am not uncertain” in our stock selection. With information asymmetry not just a feature but one of the key reasons markets exist maybe the best we can hope for is less uncertainty. Hence insider dealing and ownership should be incorporated as factors to consider in a portfolio decision making framework.

Not already a Livewire member?

Sign up today to get free access to investment ideas and strategies from Australia’s leading investors.

Further Reading