During the coronavirus crisis the level of director share buying compared to sales has rocketed and research by broker Liberum has confirmed how effective director dealings can be as a signal for investors.

“A director purchasing a significant value of company stock is a contrarian buy signal,” said investment strategist Joachim Klement, with buying and selling often contrary to recent price action.

READ: Wetherspoons boss sells shares, pubs cut prices

This is based on analysis of a five-year database of director deals he and his team have kept, purely of discretionary transactions in UK and European companies executed on behalf of the company’s directors. 

Liberum’s definition of “purely discretionary” refers to open market transactions only, so excluded grants, awards, dividend reinvestments and those related to employee stock plans.

The analysts acknowledge that directors’ motivations for insider transactions can be manifold, including buying and selling some of their stock to ‘rebalance’ their holdings, to pay for personal expenses or personal circumstances such as for taxation, house purchases or divorces. 

To reduce the impact of such trades that may be triggered by rather than a conviction in the company’s fortunes or as a public sign of confidence in the company, the Liberum team set a minimum trade value equivalent to 0.025% of the company’s market cap, so a minimum trade value of £25,000 for a company with a £100mln market value. 

Also, a minimum market capitalisation of £100m was applied, which was said to try and exclude the idiosyncrasies of this set of companies.

The research finds that significant director transactions make for “effective, short-term and contrarian signals for both buying and selling stocks”, with the signal more effective for smaller companies with less than £1bn in market cap. 

Following a significant purchase of company stock this would be contrarian buy signal, Klement said, with the research indicating this would typically have generated total returns of 1.21% in the month after the trade was announced. 

Relative to the FTSE All Share these stocks outperformed on average by 0.35% and on average was a reversal of the shares’ performance in the month preceding the insider purchase, which was down 1.03% on a total return basis and down 0.8% for the relative return. 

However, two and three months after the trade the company’s performance appears to fade again, the research showed. 

For significant director sales, such as the £5mln sale by Wetherspoons boos Tim Martin revealed last week, this can be used as a sell signal, Klement said. 

The total return has been flat for the month after an insider sells some of their shares, the research showed. 

“Interestingly, though, the return relative to the broader market is also roughly flat, indicating that insiders tend to sell at times when they perceive the market to be overvalued or running out of steam,” Klement said. 

“In an eerily similar fashion, over months two and three post the trade report date a partial reversion to the stock’s prior returns trajectory is observed and both total and relative returns increase again.”

But he added that there is also bad news for investors looking for long-term signals, as director dealings do not seem to form effective signals for relative outperformance over a 12-month holding period. 

In other words, after one month there is a gradual but steady reversion to its prior relative performance and once normalised this relative rate of return then compounds over time.

However, Klement noted that the past five years has been a relentless bull market and contrarian investing strategies have not performed well over the time period of this analysis. 

But saying “when life gives you lemons”, he suggested selling stocks a month after insiders bought them and vice versa and then holding them for 11 months “could be a way to outperform the market”. 

“If insider buying and selling knocks the share price off course for a month, so to say, why not wait for that to play out and then invest in such a way that you benefit from a reversal to previous trends relative to the market? Our results suggest that this strategy could in theory be profitable.”

However, in practice there are several important obstacles to overcome and the strategists warned that “overly brash director purchases not executed with discretion are typically deliberate attempts at instilling confidence… These signals should therefore be interpreted with scepticism when the required holding period extends to twelve months”.