More than Just Contrarians: Insider Trading in Glamour and Value Firms

Author:Ian Tonks, Rajesh Tharyan, Alan Gregory
Publication Date:01 Sep 2013
Introduction

It is well‐known that value stocks have higher returns than glamour stocks in the USA (Lakonishok et al., ) and internationally (Fama and French, ). In addition there is evidence that corporate insiders can trade profitably on their private information (Ravina and Sapienza, Friederich et al. ; Gregory et al. ). This paper investigates the interaction of the value‐growth anomaly with the returns to insider trading, to see whether corporate insiders recognise the publicly available value‐glamour return differences as mis‐pricings and trade on them. In particular, we assess whether corporate insiders’ private information is able to generate additional abnormal profits over and above trading on value‐glamour mis‐valuations. Lakonishok and Lee () and Jenter () have examined this question for the US stock market but produce conflicting results as to whether any abnormal returns remain to insider trading, once an allowance is made for the size and value premia. Our study provides additional out‐of‐sample evidence for a different stock market, and in doing so provides confirmation that the value‐growth anomaly is based on mis‐pricing rather than value stocks being riskier investments.

Our results can be summarised as follows. First, we find evidence in the pattern of UK directors’ trades that is consistent with a contrarian view of the mis‐valuation of value and glamour stocks: directors of value firms tend to buy into their own company stock, and directors of glamour stocks are net sellers. Second, UK corporate insiders generate abnormal returns over and above a simple contrarian strategy of buying value stocks and selling glamour stocks. Third, we show that these returns appear to be concentrated in small value stocks in particular. Fourth we show that our results are robust to alternative measures of value‐glamour stocks. These results are difficult to reconcile with a view that such stocks are fundamentally riskier, unless one accepts that directors in such companies have particularly risk‐seeking utility functions.

We go considerably further than the extant US studies in investigating whether directors trade in a contrarian fashion, by considering alternative definitions of value. We assess the returns to directors’ trading relative to cash‐to‐price (CF/P), earnings‐to‐price (E/P) and dividend‐to‐price (D/P), in addition to the book‐to‐market (B/M) measure of value employed in the earlier papers. These definitions CF/P, E/P and D/P have all been suggested as alternatives to B/M for identifying value stocks. Dissanaike and Lim () show that cash flow measures generate stronger risk‐adjusted returns than either book value or earnings based measures, an effect that persists for two years post portfolio formation. We specifically consider the D/P ratio as companies with high dividend yields have been shown to outperform companies with low dividend yields, and this is a classification of value that has not be considered by any US study. It may be the case that sectional sorts on dividend yields could give rise to quite different classifications to those obtained using CF/P and E/P ratios, as dividends cannot take on a negative value although yields can be zero. Both Lakonishok and Lee () and Jenter () form portfolios based on cumulated past trades over a number of months and compute only the buy‐and‐hold returns. Ravina and Sapienza () also utilise a buy and hold abnormal return metric, but relative only to market returns. We improve on the measurement of long‐run returns by computing a range of long‐run return metrics including both buy‐and‐hold returns, and calendar time returns in a monthly event study framework where the event month is the month of the announcement of the trade.

In the next section we review the literature on the value premium and its relationship with studies of insider trading, allowing us to develop our hypotheses. In Section 3 we explain our methodology to examine the interaction of directors trading with contrarian investment strategies, and Section 4 describes the data set on UK corporate insider trades in all stocks listed on the main London Stock Exchange over the period 1986–2003. We present the results in Section 5, and Section 6 provides our conclusions.

Literature Review and Development of Hypotheses
Contrarian investment strategies

Contrarian investment strategies, buying (selling) stocks with low (high) prices relative to fundamentals, as an investment strategy has existed for the past 70 years, but confirmation of its existence was in large part due to the work of Fama and French (, ) and Lakonishok et al. (). While some authors (Kothari et al., ; Black, ; MacKinlay, ) have argued that these observed premiums are artefacts of the methodology adopted, due to survivorship bias, beta mis‐measurement and data snooping, the wealth of international evidence discounts this argument. However the interpretation of the value premium is contentious, and there are two commonly accepted, but conflicting, explanations. One is a rational risk‐pricing explanation (Fama and French, ), suggesting that because value stocks are fundamentally riskier than glamour stocks (Zhang, ), they therefore deliver greater returns as compensation for bearing that risk. The second explanation is based on the irrational behaviour of investors (Lakonishok et al., ). The central idea behind this school of thought is that investors systematically overestimate the potential of growth firms to produce superior returns and these systematic errors are responsible for the superior performance of value stocks. Dissanaike and Lim () investigate the performance of a range of portfolio formation devices, ranging from simple sorts on book value, cash flow and earnings measures, to more complex models employing variants of the Ohlson () model and a residual income model (RIM) over the formation period 1987 to 2001. Whilst a version of the Ohlson model and the RIM are the two best performing models, portfolio sorts on cash flow measures are not far behind. As the authors conclude (p. 251) ‘Our most intriguing finding is that simple cash flow multiples appear to have almost as much power in predicting future contrarian profits as the more sophisticated alternatives’.

Trading by corporate insiders

Although early work on corporate insider transactions by Jaffe (), Finnerty () and Seyhun () identified a stock price reaction to these trades, more recently Lakonishok and Lee () find little evidence of any announcement effect of insider trading. Pettit and Venkatesh () suggest that corporate insiders’ desire to disguise any informed trading means that it is more likely that they will trade on the basis of information that is only revealed in the long‐run. Lakonishok and Lee () find some evidence of long‐run abnormal returns after conditioning on size and book‐to‐market characteristics of the firms. But Jenter () concludes that long‐run excess returns, after controlling for size and book‐to‐market effects, are indistinguishable from zero. These somewhat mixed findings on the stock market response to corporate insider transactions in the USA are in contrast to the UK and other countries where studies have shown there are significant short‐run and long‐run abnormal returns to directors’ trading (Gregory et al., ; Friederich et al., ; Bris, ; Fidrmuc et al., ; Betzer and Theissen, ). Fidrmuc et al. () explain the greater short‐run informativeness of UK directors’ trades in terms of the regulatory differences between the two markets, because prior to 2002 the required disclosure of insider trades to the market was faster in the UK. Brochet () confirms this conjecture that the disclosure regime does have an impact on short‐run stock returns. He finds that after the more timely disclosure of US insider trades under SOX 2002, abnormal returns and trading around filings of insider stock purchases were significantly greater after SOX than before.

Interaction of insider trading and contrarian strategies

If glamour firms either underperform and/or value firms outperform in the long‐run, then we might expect corporate insiders to trade to take advantage of any perceived mis‐valuation. However, buying value stocks and selling glamour stocks would be a simple contrarian strategy which one might expect to see taking place in the absence of any information from insider trades. Whether such strategies generate genuine abnormal returns, net of any risk effects, remains controversial in the absence of a wholly convincing asset pricing model. We attempt to provide insights into this controversy by examining the abnormal returns over and above those that might accrue to a simple value‐glamour contrarian strategy.

There are good reasons to believe that managers may engage in such contrarian strategies. There is evidence from the corporate finance literature on the relationship between market mis‐valuations and corporate events like IPOs, mergers, SEOs and share repurchases with managers adopting strategies to take advantage of these mis‐valuations. If these events are motivated at least in part by their beliefs on the market's valuation or mis‐valuation then it is entirely plausible that they will trade strategically when trading on their own accounts in their companies’ stocks. So an analysis of insider trading patterns across value and glamour firms provides interesting prima facie evidence on whether or not value firms are so priced because they are simply riskier, in which case we would not expect to see directors trading any differently between value and glamour categories, or whether such pricing (at least in the case of the sub‐group of firms in which insiders trade) looks like mis‐valuation. Of course, the basic assumption underlying this is that directors who buy in value stocks are unlikely to want to load up more on risk than those who buy in other stocks.

There is evidence from US studies that insiders indeed trade in a...

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