Originally published by Cuffelinks
A company’s directors, particularly executive directors, have more insight into a business than anyone else in the market. Therefore, we are generally sceptical when a company’s board member substantially sells-down their ownership as it can signal a negative outlook for the company. Furthermore, a substantial reduction in a director’s equity diminishes their ‘skin in the game’, which helps align their interests with shareholders.
Skin in the game
In our experience, when management (including directors and senior managers) have equity in the company they are running, it is likely to outperform other comparable businesses. This is particularly the case when the founder maintains a stake in the company. Managers with ‘skin in the game’, a term famously coined by Warren Buffet, have more exposure to the performance of the company they are running. This creates an inherent incentive for them to act in the interests of the company and its shareholders.
When we assess a company as a prospective investment, we always consider how management’s interests are aligned to its shareholders by evaluating remuneration structures including base salary, bonuses and performance hurdles. Our focus on management’s equity stake in the business also applies to our analysis of IPOs, particularly those businesses that are yet to generate a profit.
Scrutiny of Appendix 3Y Notices
ASX-listed companies must notify the stock exchange (within five business days) using an Appendix 3Y – Change of Director’s Interest Notice when directors acquire or dispose of its shares.
Appendix 3Y Notices can provide valuable insights and we closely monitor these announcements on potential investments as well as those already in our portfolio. We pay particular attention to share sales by executive directors (such as CEOs) with responsibility for the day-to-day operations. Their decision can sometimes be tantamount to a vote of no confidence in the future prospects and may be a signal for us to sell-out of a holding, or at least seek to understand the rationale for the sale. Conversely, a company’s directors increasing their holding typically indicates a positive outlook and their ongoing commitment.
Director sales
Over the last 12 to 24 months, the market has seen the spectacular collapse of numerous company share prices. In many cases, the share price rout was preceded by significant sell-downs by company directors including:
Bellamys Australia Ltd (AX:BAL). Former Managing Director and CEO Laura McBain and then-Chairman Rob Woolley sold 14.2% and 44.2% respectively of their shares in Bellamy’s. The sales in August 2016 for $14.60 were made just days before the stock hit an all-time high of $14.90 a share. The disposal of shares in the former market darling proved a portent of Bellamy’s share price performance with its stock plummeting around 69% off their high to trade around $4.61 each at the time of writing.
Vocus Communications (AX:VOC). Founder and director of the telco James Spenceley substantially sold-down his stake in the business for $26.7 million in August 2016 before the company downgraded its profit guidance in November. Shares in Vocus are now down 54% from their May 2016 high.
Estia Health Ltd (AX:EHE). After the company missed its profit guidance, director and founder of the aged-care operator and developer, Peter Arvanitis, surprised the market in August 2016 by selling his entire stake in the company (around 10%) for $3.15 a share (which compares to a high of $7.41 earlier in the year), or around $55 million. Simultaneously, Mr Arvanitis resigned as a director. The company’s share price had already declined sharply in the months leading up to Mr Arvanitis’s decision to sell-out and continued its decline with the company cutting its profit outlook in October 2016. Shares in Estia have since recovered to trade around Mr Arvanitis’s sale price.
Research reveals correlation
Our belief that insider sales can be a potent indicator of a company’s future performance was buttressed by recent research. An analysis by stockbroking firm Wilsons (not related to Wilson Asset Management) of Appendix 3Y Notices announced to the ASX in 2016 found that, of the companies whose management sold large parcels of shares, 76% underperformed following the sale with their share prices falling an average of 14% (excluding companies with a market capitalisation of less than $50 million and listed investment companies).
The research also found the larger the value of the shares sold, the greater the risk it would underperform. Interestingly, the disposal of shares of any size by a director holding the position of CEO, CFO and/or COO was correlated to significant underperformance of the share price.
When director selling is a positive
Insider sales are not always an ominous sign and director sales can sometimes be a positive for the company outlook. For example, a director that has sold shares but still holds a large parcel may be motivated to ensure a continuing and positive relationship with the buyer because they want to sell again in the future. Also, when a director is selling shares but leaving ‘something on the table’, it can give us confidence in the future prospects of the company. As an example, the executives at Monadelphous Group Ltd (AX:MND) over the years have generally sold and left money on the table.