How to be a better investor: Lesson 5

Getting the gist on why an investment is popular goes part of the way to answering some fundamental questions. The social mediatization of investing is not quite a new phenomenon as recent events with GameStop in the US would suggest, but investment expert Julian Hofmann explains why it is worth taking the time to look out for vigilantes.

Understanding the reasons why a particular share is attracting attention and which groups of investors are buying, or by the same token selling it, is another important step in the process of carrying out a thorough due diligence check. 

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Directors’ dealings

Directors of UK companies are required by both London Stock Exchange’s rules and the 1985 Companies Act to declare their share dealings by making an announcement to the stock exchange. The rule applies to any executive or shareholder who has access to privileged insider information.  

The timing of these transactions is closely watched by the market, on the basis that no one knows the state of the company better than its management team, so executives buying large chunks of shares in the period before results season could be a sign of good news to come. The same is true of the reverse proposition, that directors who are selling shares could be cashing out before dropping a bomb on the share price. 

• Read more from our Insider column focused on the most interesting director deals

When confidence tips into delusion: the HBOS fiasco

The collapse of HBOS revealed a startling lack of insight by management into the risks that the business was running. As we have discussed before, HBOS, along with the other banks that collapsed had few senior executives with much actual banking experience. 

HBOS is also a case study in why marrying two fundamentally different businesses can have detrimental effects – Halifax, the high street mortgage lender sat uncomfortably with Bank of Scotland’s riskier corporate finance activities and it showed in the sub-standard oversight by the board.  

There is also a lesson in why tracking directors’ dealings is only a partial guide to management thinking. In his evidence to the parliamentary inquiry into HBOS’ collapse, the former chairman Lord Stevenson said that he had not sold any stock, or exercised any options under his long-term incentive plan, in the three years prior to HBOS’ collapse. While his confidence in the business can be described as commendable, it also begs the question as to whether he really understood it any better than an outside investor. 

An important question to ask yourself is whether the management has “skin in the game” when it comes to staying invested in the business. The orthodoxy over the past 40 years is that management owning shares in the business aligns them with shareholders’ interests – a theme we touched upon previously in our look at the theory of shareholder value. It is also a maxim that professional investors like Warren Buffett follow, with varying degrees of success.

The important thing to remember is that it isn’t an exact science and is open to a lot of guesswork and interpretation. In particular, the definition of “dealing” is defined very broadly indeed. Companies have often complex reward schemes that vest automatically when certain milestones have been reached - given that profits are often retained in a business for a year before paying them out in some form, this could relate to prior performance rather than reflect the current situation.  

It will also depend on the time of the year. For instance, the most common reason given for share sales by directors is the need to cover a personal tax liability, which makes perfect sense when it comes round to tax return time. 

A confidence boost

The thing to remember about the stock market is that, in many ways, it is a barometer of peoples’ collective sense of confidence. Directors know that part of their accountability to their shareholders is the need to maintain confidence in their management and strategy. If confidence drains away, then a company can be very quickly ensnared in a death spiral. 

That is why you will often see director buys in the aftermath of bad news. 

These are basically a signal that the management has underlying confidence in the business and that any dip is an opportunity to buy. This can also be done cynically – analysts will often point out that the director buys in such a scenario are often small in monetary terms. However, it is still true that investors tend to over-react to news, both positive or negative, so assessing whether this is the case is an important part of your due diligence thinking. 

The madness of crowds

There has been a real sense of history repeating itself recently with the recent massive increase in the number of retail investors, along with concurrent rise in share trade volumes. These are starting to rival those of institutional investors for the first time since the dot.com bubble burst in 2001, with some estimates putting retail investor trades at one third of all stock market trades – rivalling hedge and mutual funds. This comes after several years of relative stagnation. 

Part of this shift is almost certainly generational. The so-called echo-boomer group (the children of baby-boomers) are now well into their 40s and are starting to reach their peak earnings potential. They also stand to inherit substantial property wealth from their parents.   

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A new generation brings with it a new approach to sharing market information. The dot.com boom was often defined in many ways by the early communication possibilities of the internet - simple bulletin boards and investor forums provided the opportunity to share information, boost shares or carrying out unofficial marketing outside the normal pages of the financial press. 

Bulletin boards still exist, of course, but the difference now is that social media is allowing retail investors to organise en masse around a particular investment case. The other difference is that there is an almost vigilante mentality towards taking on the established players in the market. 

Do fools rush in? 

The technology and investment culture may change with each successive generation, but the basic due diligence process will always be the same. 

You might say that it is being sceptical in an organised way. 

For instance, ask yourself the same key questions. Is there a decent investment story? Why is everybody rushing to buy/sell? Who is boosting or trashing the shares? Is there a bubble forming? Does this fit with my investment strategy? What is my investment strategy?