Derek Pain: Directors' dealings are important signals for shrewd investors

No Pain, No Gain

Director share buying – or selling – is often an important signal for investors. Every week numerous deals are recorded as those at the helm spend or raise cash. Using inside information is, of course, illegal and miscreants should expect prosecution.

Still, stock market history is littered with examples of director transactions providing indirect indications of a group's prospects. But not all of them are what they seem and it is always wise for outsiders to treat what appears obvious with caution. I suppose the most bearish sign is when a director sells. Yet reasons not related to a company's prospects could prompt such action. Divorce settlements are sometimes a major influence; buying a property (or yacht) are other factors; and more mundane costs, such as school fees. There is also the claim directors should not have all their eggs in one basket and should sell down when an often commanding shareholding is held. Although the need to diversify has much to commend it, I cannot avoid a sneaking suspicion a big disposal is a far from encouraging development for other shareholders.

Another reason often put forward for director selling is that a company's stockbroker regards the market in the shares as far too thin and, in City jargon, wants liquidity improved. It is small caps which mainly encounter such demands. A number of directors are encouraged to sell to accommodate the stockbroker. I often wonder why the men and women running a business accede to such requests. There is nothing wrong with a thin market – indeed many players on the stock market undercard are dominated by boardroom shareholdings – and such sell exercises invariably leave us outsiders wondering about the old habit of cashing in while the going is favourable.

Buying shares should be an encouraging signal. However, directors can also make mistakes. It is not unknown for shares to be acquired in the belief a tottering company is actually sound. Sometimes the business fails and the shares are declared worthless. Then the buying optimism is shown to be completely wrong and buyers are left nursing loses. There are also occasions, I would imagine, when director share buying is intended to mislead. Besides insider trading, the rules governing transactions generally relate to timing, such as not trading ahead of stock market announcements. In my view, they have worked well although you cannot legislate for every eventuality.

I like to see directors buying and believe significant shareholdings exude confidence. It was encouraging to see Andy Harrison buying shares in Whitbread, a no pain-no gain portfolio constituent, when he became chief executive. And this month, Blair Jenkins, already a strong shareholder, topped up his stake in small cap constituent SnackTime. Accountancy and wealth management group Lighthouse, another small cap portfolio member, has not attracted much in the way of director dealings recently but its board is already well represented on the shareholders' register.

Even so, it is surprising board members were not tempted to buy by the low share price. It was down to below 8p but has improved after research comments. Surely Lighthouse is worth more than the £12.4m, implied by its shares standing at 9.75p. After all, it has around £14m tucked away although some of its cash is needed to satisfy regulatory requirements? The group is also profitable and pays dividends.

Researcher Brokerlink concluded the shares were cheap; indeed it said they were putting a negative value on the business, which defied logic. Although dramatic changes are scheduled in Lighthouse's world of independent financial advisers, it is well positioned to accommodate them. And year's profits, before special charges, should be around £1.2m.

After the departure of Printing.com, Lighthouse is the longest serving member of the portfolio. The shares were acquired at 17.5p in August 2006, and subsequently climbed to 35p. But they slumped after the banking meltdown. The group's presence in the financial community was a major influence. Impairment charges and other factors had a dramatic impact at the pre-tax level. Still amid the mayhem Lighthouse traded resiliently and, as Brokerlink observes, the shares fell too far.