The Week Explained: Insider buy-backs
Directors of listed Hong Kong companies have been increasing the purchases of their own shares after a lull in this kind of activity earlier in the year. Also, rather intriguingly, Berkshire Hathaway has made a US$1.2 billion buy-back of company shares. The purchase defies US investment guru (and Berkshire head) Warren Buffett's own maxims.
Buffett is famous for criticising directors for overpaying for shares in their own companies, which he says is done to pump up the share price.
However, earlier in the month Berkshire stepped in to buy 9,200 class A shares at US$131,000 per share, this being Berkshire's relatively illiquid share class. The firm did so at a slight premium to the closing price on the day before the purchase was made. It was speculated he wanted to prevent the release of these shares on the market, which could have caused a fall in his company's share price.
But if Buffett expected a price drop, why not buy the shares on the open market following the decline? The direct buy-back from the selling shareholder seemed to run contrary to Buffett's mantra of taking advantage of price falls.
The name of the seller has not been disclosed but Berkshire said the shares came from "a long-time shareholder". It is not known whether Buffett had a connection with this shareholder, nor has he given a reason for the purchase.
Having preached the virtues of maximum transparency in companies that Buffett regards as good investments he might wish to practise more of what he preaches.
However, and quite predictably, it had a positive effect on the price of Berkshire shares. The logic is that company directors know best how much their companies are worth and that, when insiders see buying opportunities, this is a signal for outsiders to join in.
Hong Kong investors closely track insider buying, which has to be disclosed, even though purchases of this kind cannot be made at times when directors are in possession of market-sensitive information that is about to enter the public domain.
Ian Tonks and Alan Gregory, from the University of Exeter Business School, did a study on the benefits of following directors' buying patterns in the London market, covering transactions from 1986 to 2003. They found that directors' trades in small value-stocks were particularly good indicators of outperformance of the share price. In a typical two-year period, the value of these shares rose up to 20 per cent more than those of other firms in the same sectors. Bigger cap stocks showed a less spectacular gain of 6 per cent in the same time frame.
Less attention is paid to share sales by directors even though, if it is assumed they buy on strength, surely the corollary is that they sell on information they have about the weakness of their companies.
This matter is not straightforward because, for example, directors may well be less objective about their company's prospects than outsiders and this can lead to excessive optimism in circumstances where they believe the market has misjudged the state of play.
Moreover, they may be selling simply to raise capital for other purposes that are unconnected with the prospects for their companies.
The issue is further complicated in Hong Kong, where it is commonplace for connected parties (for example, family and friends of company directors) to trade shares on behalf of corporate insiders. These trades have to be disclosed but often sneak under the radar. There are also suspicions of proxy buying and selling on behalf of executives.
Sometimes trades by directors overwhelm the market in individual stocks and can rightly be said to be causing distortions in market prices.
This makes it hard for investors to take an absolute view on whether they should be following a director's share purchases. It's a useful share trading indicator but comes with the caveat that information about director's trades is only available after the event so the impact may already be in the price.