If you see insiders buying, it can only mean good things

There is, it seems, a price for everything. For the first time since the market plunge in March 2020 more company bosses and other senior executives were buying shares in their own companies in May than were selling them. These so-called insider buyers can be a powerful leading indicator of a change in direction for the market so, alongside the first week of positive investment returns in nearly two months, should we take heart from this apparent change of mood?

The fact that insiders are buying again is clearly a positive. Peter Lynch, the manager back in the day of Fidelity’s Magellan fund, famously said ‘insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise.’ He was right. People will dispose of their shares if they need to buy a house or end a marriage, but they won’t put money into their company’s shares unless they think, first, that they are undervalued and, second, that this is likely to change. 

After seven weeks on the trot of falling markets, it was inevitable that investors should have started to anticipate a reversal. Not since 2001, and the bursting of the dot.com bubble, had shares gone backwards for so long. Last week’s 7 percent jump in the US stock market was overdue.

Insider buying is not the same thing as insider trading. The latter, buying shares on the basis of non-public information, is quite rightly illegal. The former is the legitimate acquisition of shares by a director, officer or large shareholder in their own company in the belief that the market is not valuing those shares correctly. If anyone is well placed to make that judgement it is surely the people running the business. This is why other investors keep an eye on boardroom buyers.

One purchase that caught my eye recently was by Ford’s executive chairman Bill Ford, great grandson of the company’s founder. He took advantage of an 18pc fall in the car maker’s share price between the beginning of the year and the announcement of its 2021 results in March to buy shares worth US$4.5m at US$16.81 a share. 

Considering that the shares had briefly touched US$25 in January, it clearly looked to the Ford boss that the market was undervaluing the company’s electric vehicle ambitions (two million electric vehicles (EVs) a year by 2026) and its plan to remove US$3bn in costs from its traditional internal combustion engine business. Ford says it will make a 10 percent profit margin in five years’ time, up from 7.3 percent last year.

In the short term, the Ford boss has been wrong. The shares are under US$14 today. This is not unusual. Insiders are often too quick out of the blocks when it comes to buying their companies’ shares, something that’s worth remembering if you are looking to the boardroom for investment ideas. This probably shouldn’t surprise us too much. Insiders may know what’s going on inside their company but that doesn’t mean they are any better at market timing than anyone else. A combination of confirmation bias and wishful thinking may make them worse.

In fact, there is plenty of evidence that corporate managers are just as likely as the rest of us to suffer from common behavioural biases. One study asked finance directors on a quarterly basis how confident they were about both the economy and their own company’s prospects. They were routinely more confident about their company than the economy as a whole - a classic case of overconfidence springing from the illusion of control.

Similar studies showed managers are consistently over-confident about the future returns from their company’s shares. Finally, when asked whether they thought their company’s shares were under- or over-valued, 63 percent thought their shares were too cheap, with 32 percent saying they were priced about right. Anchoring is one very common problem - perhaps one that afflicted Mr Ford. When your shares have been priced at US$25, it is hard to avoid the conclusion that at US$16 they are cheap. They may or may not be.

So, if you keen to ride on the coat tails of the company bosses, what should you look out for? First, make sure the data is not being distorted by big but unusual trades. Elon Musk selling shares in Tesla to fund his Twitter purchase is a good recent example of this. 

Second, look at the size of the trade relative to the wealth of the investor. US$4.5m is a lot of money to you and me, perhaps less of an issue for Bill Ford. Broadly, the bigger the deal, the more meaningful it is likely to be. Likewise, the number of directors buying. Again, more is good.

Who is buying can be important too. Independent directors, especially if they have an investment background, might be more objective buyers than a company’s founder. How long they’ve been involved with the company is a good indicator also. If they have been through a number of cycles, they may well have seen it all before and have a better sense of what comes next.

Finally, look at the broader context in which the purchases are being made. Are similar insider buys going through in other companies in the same sector. This might indicate a change in sentiment within an out of favour industry.

Insider buying is just one factor in determining whether or not to buy a company’s shares. It shouldn’t be relied on in isolation, but in combination with other fundamental indicators it can provide useful information. And if you’re wrong, you will at least be in good company.

Tom Stevenson is an investment director at Fidelity International. The views are his own.