Should you worry about CEO share selling?

Recent actions at Vita Group Limited (ASX:VTG) and Bellamy's Australia Ltd (ASX:BAL) will have investors wondering if management selling is a warning sign.

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"Management sell shares for many reasons, but they buy for just one", goes the old rule of thumb.

Yet with so many insider share sales followed by downgrades recently, stung shareholders must be wondering if that holds true all of the time.

If we think about it this way, a share sale basically says that the seller has a better use for the funds than keeping them in those shares. Whether a voluntary undertaking like diversifying investments or buying a house, or a forced sale such as in the event of a margin call or divorce settlement, CEO actions can sometimes appear to be at odds with their own bullish comments on a company's prospects.

This upsets shareholders if a company's prospects later decline, like we have seen with Sirtex Medical Limited (ASX: SRX), Bellamy's Australia Ltd (ASX: BAL), and Vita Group Limited (ASX: VTG) recently.

There are three main things all investors must consider before deciding to act on director share dealings:

  • The timing

There's no really good time for an executive to sell shares. Part of the outcry over Sirtex at the moment is because the CEO Gilman Wong sold shares a month before the downgrade. Yet if he had sold shares earlier, would shareholders still be bothered? How much earlier would he have had to sell shares to avoid the accusation of selling in preparation of a downgrade? If he sold in July, as has been his custom for the past 3 years, that in itself could theoretically be interpreted as suspicious timing, as it is just before the annual report comes out.

Much earlier in the year, and he would have been selling just after the interim report came out, with the same problems. Without taking a position on that specific issue, we can see that there is potential for shareholders to see share sales in a bad light – whenever they occur.

  • The value of that 'signal'

What kind of information does a CEO share sale give you? What do you know for sure when a CEO sells their shares? Only that they have sold their shares. Earlier this year, Estia Health Ltd (ASX: EHE) made huge waves when founder Peter Arvanitis resigned and dumped his entire shareholding in a single day. Fairfax media has since commented that his sale was the result of a margin call – which was the result of Estia's downgrade two days earlier. Shares fell, a margin call was made, and the shares were forcibly sold. Mr Arvanitis might have sold his shares anyway, but at that time investors who thought the sale indicated his view of the company were mistaken.

Share grants usually form part of a CEO's salary. Factor in the desire of an executive for privacy, as well as potential for poor communication, lack of transparency or misdirection, and director share trades are poor quality information that do not accurately communicate the trader's intention.

You'd never dare buy a business on the strength of this 'signal' – what you would do first is look for info to corroborate or refute your theory, and that is what all investors should do when faced with director share sales that appear odd.

  • Times when the signal is wrong

It's easy to remember the times that directors sold in close proximity to a downgrade – a 50% share price drop will hammer that point home. What's not so easy to remember is the times that directors sold and it didn't presage a downgrade – or the times they bought shares before a downgrade. Here are a few other examples:

  • Vocus Communications Limited (ASX: VOC) director Tony Grist bought $1.6 million of shares in September – just two months before a downgrade at November's Annual General Meeting. Shares are down 38% since he bought.
  • Yowie Group Ltd (ASX: YOW) Chairman Wayne Loxton once sold a large chunk of shares and replaced them with a greater number of lower-priced options. Yowie sales have grown at a rapid clip since then.
  • Slater & Gordon Limited (ASX: SGH) CEO Andrew Grech has always been very highly aligned with shareholders. Backtracking through the announcements this morning, as far as I could tell he's never sold a share throughout the entire Quindell debacle. He participated in the capital raising in a big way, and even bought more shares on market recently. He's lost millions.
  • Blackmores Limited (ASX: BKL) Chairman and significant shareholder, Marcus Blackmore, sold $5 million in shares at $77 apiece – right before the price went to $200. While I imagine he kicked himself all the way up, Blackmores shares are still worth $104 apiece, 18 months later.

I'm just scratching the surface here, but we can see a wide, wide range of company outcomes have followed CEO dealings in the past. A big share sale might get you questioning the company, but it's only the starting point of your investigation, not the end.

Motley Fool contributor Sean O'Neill owns shares of Bellamy's Australia, Sirtex Medical Limited, and Yowie Group Ltd. The Motley Fool Australia owns shares of Bellamy's Australia. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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