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Can following insider’s trades lead to better investment returns?

Sep 21, 2020

Welcome to Finance and Fury. In this episode be looking at one piece of information in the share market – insider trading

There is a lot of information in the markets that can be looked at – can look at the fundamentals of an individual company – can also look at systematic information – economic indicators

In this episode – look at one specific bit of information which markets provide and that is the behaviours of insiders of the share markets – specifically directors or people working in management in companies (what are considered insiders) buying and selling shares and if this is a good indicator of the share price performance

  1. When talking about insider trading in this episode – won’t be talking about the insider trader that most people might know – what you might see in a TV show or in media headlines about one trader being arrested - insider trading is actually a legal practice that despite the common misconception –
  2. does exist and is perfectly legal as it is in a governed way – such as say Elon Musk, or Bezos or Buffet buying or selling their holdings in Tesla, Amazon or Berkshire – this is what we will be focusing on in this episode

 

To start – looking at the behaviour of investors in the market –

  1. There is a theorised relationship on how information affects markets – it is either 100% responsible for market movements or at least contributes to the price movements somewhat –
    1. either way – information can be one of the key reasons buyers and sellers are willing to buy a share at a given price
    2. investors try to make perfect decisions with imperfect information all the time – but the overall demand for a share based around information can lead to the price movements
    3. Sometimes – people buy a share with no more information than that they know the company and have seen the price go up – so they get on the bandwagon
    4. But what about someone who has almost as near to perfect information as is possible? Such as an insider for a listed company – compared to you and I they would be much closer to having perfect information - so surely their decision making on purchasing shares would be better informed – the outcome of their performance on the shares should improve when compared to the average joe
    5. This is one major reason that when insiders are either buying or selling their shares – it is information for us –
      1. It might be encouraging for the market when insiders are buying more of their shares – as this may mean the price is lower than expected
      2. Or if an insider is selling – it might show that they think a company is overvalued
    6. However – it might just mean they have additional cash lying around or they are going through a divorce or buying a multimillion-dollar house and need some surplus cash
    7. But you can know this information – on a register – and can use sites like - Market Index
      1. can’t verify the accuracy or completeness of the information contained on their website - it does appear to offer a decent insight into the owners of shares on the ASX as well as the movements of share buys or sells by those individuals/trusts/companies

 

What can information can be gained from looking at insider trading

  1. The concept comes down to these insides being the owners of these businesses, as well as having inside information but also – they also have some say in the companies direction -
    1. If someone is an owner of shares in the business they are running – they will probably have much stronger alignment with the interests of other shareholders – that is to make a positive return in the share price – why else buy a share?
      1. Compare this to non-owners – in the forms of executives without significant stakes in the company – if they are on the board
      2. On the other hand – some CEOs might run a pump and dump of a share in their tenure without actually making the company a good long term performer – that is where the incentives do need to be monitored closely – hence why with most share schemes for management they have a period in which they cant sell the shares for years after leaving the company – unlike in the past when this was more of a problem
    2. Another somewhat obvious point is that the smaller the company is - the more likely it is for founders and owners of the shares to exert more influence over the direction and success of the company
      1. Not only are they emotionally invested being the founders – but heavily financially invested - hence it further aligns the interest of the CEO to the shareholders
      2. This has been an interesting point when talking to fund managers – they pay close attention to small cap shares that have the founders/CEOs with large ownerships in the business
  • However – the smaller the company – no matter how passionate a founder/CEO might be – their company may underperform
  1. So, is there any evidence that following the insiders actually works?
  2. Thankfully – others have done the work for this – there are plenty of studies over the years – both in the US markets and in Australia that have attempted to quantify the impact of returns out of following the flow of shares from insider dealings
    1. This topic does draw debate form both sides around its application when actually making a decision on buying or selling a share – but based around some studies – there is some evidence to support the notion of following insiders can lead to outperformance of the market
  3. US markets
    1. Special information and insider trading – released in 1974 – so rather old and only looks at the years between 1962-1968 – it does show that there is an outperformance in the market of around 7% p.a. over those 6 years from either buying shares when the insiders are buying, or selling when they are selling
    2. Estimating the returns to insider trading: a performance-evaluation perspective – released in 2003 – went through the years of 1976-1996 – showed that there was a return of around 6% p.a. outperformance from following the insiders
  4. Aus Markets
    1. Information trading by corporate insiders based on accounting accruals – study from 2006 – followed the years between 1996 to 2003 – showed a 4.3% outperformance level as an average
    2. Insiders profits in the Australian Equities Market – shows that outsiders incur loss if they follow insider’s purchase in all firms
      1. However - for large stocks - earn on average 1.02% 2 weeks, then up to 1.88% and 2.32 % (t-statistics=1.82) 3 and 6 months, respectively, after they purchase stocks.
      2. On the downside - The results for sale transactions across all stocks and size groups show that outsiders make profit over all window periods after they sell following public announcement of insider’s sale. However, the abnormal return after a year for small and medium size stocks is statistically insignificant.
  • The results over all transactions (buy and sell) for small stocks show that there is a loss for outsiders after 3 and 12 months if they follow insider’s transactions in small firms. However, outsiders who follow insiders in large stocks earn an increasing abnormal return from 0.29% after a week up to 5.3% after one year following the insider report date.
  1. In summary, outsiders can make profitable trades by following insider’s trades in large firms, but the abnormal returns of doing transactions following insiders in small and medium size firms are limited to insider’s sale trades.
  1. This is not an exhaustive list of studies and it doesn’t include those that argue against following insider trading
    1. The issue with most of the studies for insider trading is they only follow a relatively short timeframe – the average is about 6 years’ worth of data and the older ones that do follow say 20 years of data were working under different market conditions
    2. Points to look out for – Following an insider’s lead may work in some cases – or they might work at all –
      1. It is almost impossible to know the motives behind the buying and selling decisions of an insider – however – lets look at some recent movements on the ASX and in global markets
      2. A2M – there were material share disposals in August 2020 by the Chairman, interim CEO, AsiaPac CEO and other Executives in the company
        1. Price was around $19 at this time – since then has declined to just above $16 – so either others in the market are paying attention or the outlook for the company might not be so great
  • In the technology space – there have been recent accounts of many directors selling in a number of technology companies – this is one area of the market that is speculated to be in a bubble
    1. Even family members – like Kimbal Musk (Elon’s brother) sold36,375 Tesla shares at a weighted average price of about $482.59 around the 31st of Aug – netting $8m – this was right before the price drop – that had a bit of a rebound recently – but is still over 10% lower
  1. Few key takeaway points -
    1. Directors buying might be better information than if a director is selling
      1. An insider might sell their shares for any number of reasons - but they are probably only going to buy them for one reason – they think it is undervalued and the price will go up
      2. This being said those - buying can sometimes be an action an insider may take to game the market – this would especially be the case in small cap markets where investors pay closer attention to this – smaller amounts of capital can raise the price by more than what it would in a CSL – could be in an effort to raise some additional capital from the markets
    2. The more involved the insider is the better - often act well in advance of any news
      1. A CEO buying and selling is a better signal than a non-executive director
      2. Pretty obvious point – but the higher the individual in the day to day management is – the better understanding they should have on the operations
  • There are papers that have gone further – that the CFO trades are more profitable than CEO trades
  1. Another obvious point - but the more directors are trading the stronger the signal – if it is a large portion of market cap or the individuals holdings – then that is a better signal
  2. There can be many false flags

 

Summary

  1. You probably should be out there running screens identifying trades purely around what the insiders do - but still at least pay attention –
  2. If the company looks good – good fundamentals, good management and the price seems right – and insiders are buying – that might be a strong signal

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