Many investors firmly believe that you should follow “insider buying” closely. These investors’ believe that where there are lots of insiders buying their own script, you should follow suit.
Is this always true? Is this ever true?
Well, like usual, the answer is yes and no.
Here’s is some interesting background reading on insider trading thoughts in the US. Generally speaking, I tend to agree, but I am going to give an additional spin to the traditional theory here.
There is a big difference between knowing the inner workings of a business and knowing how much its shares are worth.
At the risk of making a massive generalisation, I find that management teams overvalue their own stock. This is simply explained in a list, one bias leading to the next: managers tend to be confident people, managers tend to back themselves, and, thus, managers tend to be overly optimistic regarding their company’s prospects. Hence, the combination of optimism and (potentially large) ego leads managers to value their companies as extensions of themselves at multiples the market would laugh at (and that are unrealistic).
Perhaps read this rather lengthy piece from Harvard Business Review to get an idea of what I mean by insider optimism and ego. Then consider the fact that I don’t believe that we have ever had a CEO of a gold miner that was a bear on the gold price…
Then there is the fact that most CEO’s of listed companies are great experts in their fields, but their fields are often not the valuation of businesses and shares.
Like I said earlier, there is a big difference between knowing the inner workings of a business and knowing how much its shares are worth. Even if a company is doing well, its shares may be overpriced.
The one exception may be financial companies, and specifically asset managers and investment holding companies.
If I see, for example, Coronation (CML) or Prescient (PCT) management buying their own stock, I sit up and take notice. Likewise with Anchor (ACG), Sygnia (SYG – Sygnia’s management team actually sold a large pile of their shares upon their recent listing), PSG Konsult (KST).
This likely also includes the investment holding companies that effectively buy and sell businesses for a living, for example, PSG Group (PSG), EnX (ENX), Stellar Capital (SCP), Brimstone (BRN) and a number of others.
Finally, even if the management team are blindly optimistic and clueless on how to actually value a stock, it is always encouraging to see them buying their script en masse. I would much rather have them buying the script than selling it.
After all, a person can sell a share for many reasons (of which overvaluation is only one of them), but a person only buys a share for one reason: they believe it will generate a good investment return.
Food for thought.
Keith McLachlan is a fund manager at AlphaWealth
This article was first published on SmallCaps.co.za here, and republished with permission.