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5 actions to watch in management share buying

Watching the commitment to buying shares by senior executives and board members can be a powerful pointer to company prospects, but investors need to read the right signs.

There are many possible reasons to sell a stock, but a good reason to consider buying is when directors and management are investing their own cash into their company. Management alignment is core to the NAOS investment beliefs, backing people who are proven managers who are aligned with their shareholders. When managers are invested alongside fellow shareholders, they run their business for the benefit of all owners rather than their personal near-sighted financial gain.

Management and director buying activity is not to be confused with the issuance of ‘free’ shares as a form of compensation, but rather those instances where after-tax dollars are invested by these individuals.

What specific actions from management are we looking for?
 

1. Buying during earnings downgrades

A natural knee-jerk reaction to an earnings downgrade is often a sharp share price fall, followed by analysts pulling back their numbers as the underwhelming result is often assumed to be indicative of future performance. A downgrade can likely lead to not only a reduction in earnings but also a reduction of the multiple applied to a stock. Despite this, downgrades can present an opportunity if the cause of the downgrade is not systemic to the business operations. Whether it is timing related or a one-off, it is important to watch how company management reacts (or doesn’t react).

An example in our investment universe is invoice financing business Scottish Pacific (ASX:SCO). SCO was an IPO borne out of private equity combining three businesses into one. After being listed for a few months, it downgraded earnings due to integration issues caused by having all three businesses under one new roof. Over four weeks during late 2016, every SCO director bought shares on market, some buying over $1 million in multiple parcels. In particular, the CEO published four ‘change of director’s interest’ notices in three weeks. Since that time, a 60% total shareholder return has been generated over 18 months.

It pays to be careful where the opposite is true. If management and directors don’t buy after downgrades, there could be more pain to come.
 

2. Acquisitions on market

It is commonplace for an acquisition to have a cash and equity portion; this can be a great way to foster alignment with the management team who have just sold their business and partially cashed out. A lot less common, but a very powerful statement, is when the acquired management team purchases stock in the parent company on market, in addition to the shares they received for their business. It shows faith when their business is wrapped into the new entity.

A recent example was Gentrack (ASX:GTK), a dual-listed utility and airports billing software company which acquired a competitor in the UK called Junifer Systems in March 2017. The Junifer Systems management team received a blend of cash and shares and stayed on to work within the larger GTK group. Within six months, the Junifer Systems Managing Director purchased circa $2 million of GTK stock on market. That buying activity proved to be a positive signal for the realisation of revenue synergies, as the GTK share price has almost doubled.
 

3. Participation in rights issues

A heavily-discounted rights issue can be a sign of a company in trouble, but it could also be a chance to ‘reset’ the balance sheet or fund a big acquisition. If the market believes a company has a ‘funding hole’, a non-renounceable (non-transferable) rights issue can help mitigate a general sell-off. A rights issue can also be a great barometer for a board and management team’s long-term commitment to the business.

Take for instance TPG Telecom, a great Australian success story. TPG has two large management and director shareholders: CEO and Founder David Teoh and Robert Millner via conglomerate Washington H Soul Pattinson. During April 2017, in a $400 million rights issue needed to enter the mobile market, these two pre-committed to take up their full pro-rata entitlements by investing a combined $240 million of after-tax dollars into the business.

Other recent examples have come from founder- and family-led Australian success stories, Reliance Worldwide Corporation (ASX:RWC) and Reece Limited (ASX:REH).

All three of these businesses have delivered strong results, and the leaders are showing confidence that this will continue. Leaders who want to protect their equity position as they grow their businesses are the ones you want to back.
 

4. Continual buying

A cynical view on director buying is that sometimes it is done just for market optics. When a director with a minimal shareholding buys a nominal parcel, particularly after negative company news, we give this less weight than a director or manager who acts with conviction with meaningful buying.

We take notice of individuals with an existing large shareholding who are willing to buy more, especially when it is consistent and incremental. Nick Politis of AP Eagers Ltd (ASX:APE) is the master of this. In the ASX announcement records of APE, his change of director interest notices are consistent.

A small-cap business with similar traits is travel agency Helloworld Ltd (ASX:HLO). Managing Director Andrew Burnes and his Executive Director wife Cinzia Burnes own over 30% of issued capital. They do not partake in incentive programmes and pay themselves relatively modest salaries. The outcome is a pure focus on share price and dividend growth, and generating returns for shareholders.

 

5. Stepping up to the plate

A new CEO appointment is typically accompanied by an announcement to market with the remuneration package containing an incentive plan. It is rare for an incoming CEO or director to commit a substantial pool of capital at the time of appointment. When this does occur, what better sign than buying stock on market to ensure ‘sweat equity’?

When appointed in August 2013, GUD Holdings Ltd (ASX:GUD) CEO Jonathan Ling purchased $500,000 of stock on market within the available trading window post appointment. Five years on and his shareholding has continued to increase whilst a +160% total shareholder return has been generated.

As investors, we are buying into businesses rather than just stocks, and alignment with shareholders from the management and boards is critical. We buy into high-quality, proven management teams with ‘skin in the game’. Some of the actions we have discussed here are too rare a sight on the ASX. We would implore more company principals to demonstrate their long-term commitment by adopting some of the above behaviours.

Content first published in the financial newsletter cuffelinks.com.au on 15 August 2018.