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Beat the market by following director share buying

One way that foolhardy brave investors look to beat the market is by following the share trading of company directors in their own company’s shares.

Directors are not allowed to trade on inside information.

But they are arguably best-placed to read the runes about their industry, and to know how much their own confident talk is hot air, versus a hot tip.

At the very least, if the financial director of Widgets, Giblets and Co. is prepared to put £50,000 into shares of the company he manages, you can be pretty sure it’s not about to go bust.

Now academics have produced research that claims to prove that following director buying of Value stocks can indeed generate superior returns.

Following director selling was found to be pretty much a waste of time, though.

Directors buy value

The new research comes from the University of Exeter Business School.

Professors Ian Tonks (pictured above) and Alan Gregory found company directors consistently trade in a contrarian fashion.

This means they buy more Value stocks and sell more Glamour stocks, and they buy following price falls and sell following price rises.

The professors define Value and Glamour stocks in the usual way:

The research covered every director’s share trade made on the London Stock Exchange between 1986 and end of 2003, although certain trades were removed:

The share price performance following a trade was analysed over a two-year period to the end of 2005.

Market beating results from directors dealings

The heaviest out-performance was concentrated in smaller value companies.

Directors’ trades in these small value stocks showed an average abnormal share price return of up to 20% more than control groups of similar firms over two years.

Directors’ trades in large value stocks demonstrated a more modest outperformance – just over 6% over the same period.

According to the paper’s co-author, Professor Alan Gregory:

“Our research shows that corporate insiders – both non executive and executive – make use of their private information to generate abnormal returns. This information is not reflected in the metrics constructed from publicly available information.

Directors’ trading signals clearly significant returns on Value stocks on the Buy side, whereas the modest negative returns on the ‘glamour’ stocks’ sell side are not generally significant”

Why following selling doesn’t work

It makes intuitive sense to me that following director selling isn’t very useful.

A director may sell shares for any number of reasons:

In contrast, about the only reason anyone buys shares is because they think they will go up in price.

The exception is ‘token’ share buys by directors who are trying to signal to the market they have faith in their company, when perhaps they don’t.

The professors exclusion of trades under £20,000 in size probably got rid of most of this buying from all but the richest directors.

Should you follow the directors who buy?

At least one professor is backing his research with his own money, according to an interview I heard on BBC Radio 4’s Money Box at the weekend.

If you want to join him you can follow director trading using this page [1] of the Digital Look website, or in magazines like Investor’s Chronicle.

There’s also a blog dedicated to tracking UK director buying and selling called followthedirectors [2].

The fact that these resources are available shows the findings aren’t ‘new’ as such.

It’s a curious question therefore for efficient market theorists to explain why this apparently well-known anomaly hasn’t been ‘outed’ and arbitraged away by the market?

If directors have been filling their boots with bombed-out shares and getting richer in the process for 20 years, why didn’t someone else notice?

Nothing lasts forever

Perhaps this new research will popularise the strategy to such an extent that excess returns will indeed be smoothed away by myriad investors jumping on the bandwagon.

As ever, past performance is supposedly no guide to the future.

Personally, I do look deeper at a company where directors have been buying when doing my own stock picking. But this is very different from the mechanical approach tested by the professors.

As ever, an index tracker [3] is the best way for most people to invest. But if you’re going to trade then this research looks well worth taking into account.

Update:

The Motley Fool has just published an article [4] based on the same research, pointing out that you can’t buy exactly when the directors buy, and that the price will often have moved higher once they do.

This is definitely true; it’s also been raised by reader Financial Samurai in the comments below.

Directors deals are worth taking into account when evaluating a share, but they’re no shortcut to riches.

Further reading: