INSIDER TRADING IN THE U.K. STOCK MARKET
Introduction
Having one of the most advanced financial environments in the world, expectations to the UK stock market for efficient trading is huge. There are several points covered in the research proposal that justifies confidence to the level of efficiency of the UK stock market which is best represented by the London Stock Exchange or LSE. Thus, in studying the efficiency performance of LSE, we can identify potential threats and problems in the UK stock market in areas of capital allocation, corporate governance and financial stability. This research has important contribution to the existing literature. For example, the level of stock market efficiency in emerging economies is found to be similar to developed nations (Griffin, Kelly & Nardari, 2007). If this is applicable to UK, then the differences in country characteristics such as rate of economic growth and political situation does not contribute in assuring the efficiency in UK stock market contrary to the findings of Cochran & Defina (1994).
The key feature of this research is that it intends to prove the stock market efficiency of the LSE, UK’s best stock market representative, based on the most demanding criterion which is the efficient market hypothesis (EMH) under the strong-form. The occurrence of strong-form EMH is cited as being an extreme case for any stock exchanges. Under the strong-form EMH, abnormal returns that investors are pursuing will not happen even with technical and fundamental analysis of the situation. More importantly, even with the guidance of an expert consultant, the stock exchange will still not award excess returns due to the fact that all pertinent information are already conceived by stock prices. Therefore, without luck, investors cannot outperform the market return. In this research, the role of corporate executives as insider traders, or simply insiders, will be studied.
There are doubts about the efficiency of UK stock market (Chen, Roll & Ross, 1986; Hon & Tonks, 2001; Gunsel & Cukur, 2007). This research will verify these doubts whether have basis or otherwise. The general rule is that pure luck is the main cause of the scenario wherein the market gained thirty percent for the year while an investor gained thirty five or forty percent for the same year. The challenge to the strong-form EMH is that the rule’s applicability to insider trading. Insiders have two distinct features that provide them with some abilities whose effects could achieve the outcome of luck in similar manner. First, they have company information which is largely isolated to them which can be used as a guide in investing strategies. Secondly, they have direct influence on the performance of the company which presents an accessible mechanism to direct corporate performance based on their investing strategies.
Insiders can be Board of Directors (BOD), corporate officers (e.g. CEO, COO and CIO), top-level managers and other executives. Employees can acquire information and a certain degree of influence on corporate outcomes but is very limited compared to their relative intensity in the higher management. Employees and their influence on stock price are exemplified in the studies of McConnell & Servaes (1990), Chang (1990) and Davidson & Worrell (1994). In effect, insiders in this research are restricted to the preceding executive category. Strong-form EMH is a very challenging characteristic that could be acquired by stock exchanges. Insiders can use their abilities to outperform the market. That is, they will buy the stock of their own company when they expect that its price will increase in the future at a point above the market. Alternatively, they will sell their own stock when they expect that its price will decrease in the future at a point under the market performance.
There are other stances that insiders can outperform the market using what is called by Finnerty (1976) monopolistic information. With immediate access to information, insiders have both better present (e.g. what the firm is doing) and future (e.g. what the firm is planning) information than outsiders. With better information, there is a greater possibility of better decision-making and results. For example, insiders will buy stocks if they are acquainted with the information that the firm’s future will have expansionary tendencies, improved efficiency and higher earnings. Alternatively, they will sell stocks if they are acquainted with the information that the firm’s future will have slower growth, increased litigation and divestments. In both scenarios, insiders have the firsthand information and speed in decision-making that makes them outperform the market. They avoid loss immediately when they sell pending fall in price and exploit returns immediately when they buy pending rise in price.
Objectives of the Study
The mission of the study is to prove that the UK stock market is efficient. This mission will not be obtained with specific objectives in mind. It will be observed that the following objectives will reflect how we will consider in construction the remaining parts of the research.
1. To use the London Stock Exchange as the best representative to suggest efficiency conditions in the UK stock market,
2. To focus the study to LSE-listed companies who comprise the major share of capitalization in the Exchange,
3. To compare the return performance of insiders from these “elite” companies to the return performance of the market,
4. To test whether the similarities or differences in returns and return behavior are significant,
5. To discuss issues of corporate governance, stock market regulation and investor strategies based on the findings.
Literature Review
Tests for Market Efficiency
There are at least two metrics to determine resemblance to an efficient market. First, a test can be conducted though evaluation of the ability of the ongoing price to reflect market information. Another, market price can be tested whether it is an unbiased proxy of the investment cost. In these methods, there are three levels of market efficiency hypothesis (EMH) which are tested; namely, weak form, semi-strong form and strong form (Cao 2003).
Without abnormal returns awaiting investors, the weak form has the assumption that using historical or past prices and the method of forecasting are useless investment strategies because the current price already absorbs/ reflects these tools. Without steady surplus returns awaiting investors, the semi-strong form has the assumption the same as the weak form together with the current price absorption of fundamental analysis. This means that public information is useless basis for investment decisions. Lastly, without the opportunity for abnormal returns even through insider strategies, the extreme case strong form has the assumption of both weak and semi-strong form with the private information being useless.
With regards to test methods, the presence of weak form EMH is evaluated by means of random walk theory where past data of the prices are necessary to carry the test. Another method, return predictability, uses two variables such as interest rates and dividend yields to predict future returns. Further, the performance of trading strategies is studied in terms of their ability or inability to present abnormal returns. This can be applied by using filters (e.g. purchase a stock if the price rises to a pre-determined level) framed in a fixed period gap and in comparison with buy-hold approach. In addition, transaction costs of strategy implementation can also provide a more conservative view of this particular test.
Event studies serve as the primary testing tool for semi-strong form EMH. Compared to highly-statistical approaches as means of testing weak form, event study is rooted for the purpose of studying capital markets. Specifically, it measures how public information about current and future performance of a certain firm affects its price performance. Event studies are applied to analyze the price-impacts of stock splits, celebrity-led advertisements, discriminatory litigations, change in manufacturing practices, takeover bids, announcement of profits, modification of corporate name, and promotion to higher quality standards (Subrani and Walden 2001). In practice, event studies are represented by models such as ARit = rit - (αi+βirmt) where ARit, rit and rmt stands for abnormal return, actual return and market return respectively. The accumulated AR (CAR) will be framed in time horizons and can be contained by simply summing up ARit. Afterwards, test for significance of CAR will be executed.
For testing the occurrence of strong form EMH, there are two methods. The first method requires exploration study to indentify an investment entity that can manage the funds with superiority. However, this practice is one of the factors that contributed to the presumption that the strong form has very low probability to occur. It is hard to achieve. The second method is relatively less complicated. It necessitates evaluation of insider behaviors like the rising trend of share price in the post-report when insiders are in purchase position and a falling trend when they are in selling stance. In addition, there are also past studies that prove the ability of insiders to derive abnormal returns in reference to CAPM. In the contrast, the efforts of outsiders to the company to use insiders’ decision as a trail are commonly ended with profit frustrations especially when accounting for transaction costs.
Prior Studies on Stock Market Efficiency
Griffin, Kelly & Nardari (2007) applied standard tests to measure the strength of weak and semi-strong form market efficiency in 56 countries. In terms of the former, it is found that stock prices of larger companies are relatively more efficient than small companies. Further, although unexpected, emerging markets perform at par with mature/ developed markets when it comes to market efficiency. The weak form variables that are used to come-up with these findings are response of stock returns to market factors, the size of portfolio and past price data of companies. Time horizons are classified as days and weeks. For evaluating semi-strong form EMH, before and after conditions of income publicities are used. It is found that both emerging and developed markets experienced abnormal returns. This research concludes that there is no support to the belief that superior legal systems, regulatory framework and governance structures is not a significant determinant for market efficiency.
From voluminous studies of economists over time, proof for market inefficiencies are established and became capital market jargons (Pierce & Maberly 2002). This includes January effect, Monday effect, holiday effect and turn-of-the-month effect. Due to this evidence, it is not surprising to observe friction between the supporters of EMH and the contenders to offer anti-thesis. In the US, another anti-thesis to the existence of EMH in the US stock markets is created. This is referred as the Halloween effect. Supporters argued that the months from May to October are usually where underperformance of stock returns happen while from November to April are the reverse (i.e. above average performance). The anti-thesis suggests investors to place their bets on S&P 500 index because it is value-weighted index from November to April while shifting strategy by investing in risk-free assets such as US Treasury Bills from May to October.
Mean reversion is a term widely used in stock markets and defined as the behavior of stock prices to result in temporary highs and lows while an average price will reign in the long-run. This concept is studied in Cochran & Defina (1994). Using the stock indices from 18 countries, it is found that most of their samples exhibited non-stationary (i.e. do not mean revert) while those that do attributed their pattern greatly to variations in total return. Specifically, they concluded that mean reversion that emerged on few country samples aroused from country characteristics. This study is a huge setback from previous studies that argued the predictability of stock returns such as the works of Poterba & Summers (1988). This study also has extended samples of at least two-decade period that reduced anomalies that arise from short-period data samples that pervious researchers overlooked.
Supplementary Studies: Variables for the Three Forms of EMH
There are studies to support the cognition that increased managerial and directorial stock ownership can result to increased corporate performance at various indicators (Kim, Lea and Francis 1988). However, there are challengers of these studies which proved otherwise such as the works of Kesner (1987). In general, earlier studies are only able to use accounting as a metric of corporate results while others did not adjust returns on stock investments for risk (e.g. using government bond as a benchmark). The preceding studies on both sides are conclusive of this fault. In a more reliable and timely research, however, the findings of the former won as Oswald & Jahera (1991) supported positive relationship between insider ownership and corporate outcomes. The same relationship is present for employee stock ownership (McConnell & Servaes 1990).
Chang (1990) showed that the announcement pertaining to introduction of employee stock options resulted in positive response from the stock market except if it is rumored as a defense against takeover bids. In a refined study, Davidson & Worrell (1994) found that the response of the stock market has high positive relationship with public disclosures of employee stock ownership plans (ESOP) in the short-run. On the other hand, there is no long-run enhancement of operating performance in the post-ESOP announcement. For some samples, their second year post-ESOP announcement results even accounted for underperformance. This condition is explained by the fact that most ESOP initiatives are means to address takeover anxieties. Speculative investment would accept them as is and concretize actions by exploiting the benefits that a target company would be able to share profits into the market. In a different view, with lucrative retirement potential seen in ESOP, unproductive managers may retire early and this cognition can signal future positive performance from the market perspective.
Previous Stock Market Findings on UK Stock Market
In the study of Gunsel & Cukur (2007) using data from LSE listed companies from 1980-1993, it is found that macroeconomic factors significantly affects stock returns. These factors include interest rates, risk premium, money supply, unanticipated inflation and exchange rate. Although indications of arbitrage pricing theory (APT) are tested by previous researchers such as Chen, Roll & Ross (1986), this recent finding extended the effect of macroeconomic variables to stock markets such that degree of impact can vary from one industry to the other (e.g. one is positive while the other is negative). Further, industry return and unexpected inflation do not have significant relationship indicating the presence of efficiency semi-strong form.
UK stock market is observed with Halloween effect for samples as far as 1694. This finding concretized that there is a historical evidence of UK stock market inefficiency. Aggravatingly, the cause of the anomaly is not found. It is not the risks, relation of markets, etc. In their research, Hon & Tonks (2001) proved that momentum strategies can provide significant returns if these strategies are executed in the UK. Except for long-run periods, momentum effect is present in the stock market as investor holds the rule “buy winning portfolios and sell losing ones”. Specifically, a momentum strategy is present only on the other half of the period that the research has studied (i.e. 1977-1996). The earlier half (e.g. 1955-1976) did not post an optimal environment for such strategy since profit levels at this juncture is relatively low and also the less volatile market prior to 1976. In this stance, the UK stock market may create a blemished weak-form EMH that challenges the finding of Worthington & Higgs (2003).
Conceptual Framework
The Assurance of EMH for a Fair Game
In 1965 work of Fama, the first definition of efficient market hypothesis (EMH) is revealed wherein the perceived benefits of new information on implicit value of an asset are diluted due to competition (Malkiel 1999). The information, thus, will be reflected in current prices in abrupt manner. Given that new information is the main source of price changes of assets, the assumption of EMH would regard the new information phenomena avoiding bias while price adjustment is conducted very quickly. Therefore, the promises of investment banks and fund managers who sell their specialty on selecting overvalued and undervalued stocks for the pleasure of investors have no basis at all. The eminent situation is that before investors could rip the promised profit the targeted stock have already adjusted on the new information.
If investors and their respective fund managers can indeed use strategies to limit the assurance of EMH, this can be seen as very profitable ability. That is, they are buying shares less than their true value while selling other shares more than their really worth. On the contrary, the success of these abilities is limited by the number of stock analysts in competition. As the entities working to find mispriced shares increase, the incentive from gaining new information becomes slimmer. This is a scenario wherein the value of new information diminishes as several analysts are able to foresee them and the higher likelihood that these finding will be leaked into the market. As a result, EMH protects the market from exploitation of several investors of excessive profit. If any consolation is maintained in favor of the investors and analysts, this is to reward only very few of them from their efforts.
The theory on capital market, thus, is a good framework where EMH is valid. This theory states that the expected return on stock investments is determined by its risks (Fama 1991). Specifically, stock prices mirror streams of cash flows including the volatility, liquidity and insolvency tendencies of the source of such flows. With these arguments, there are two findings. First, new information are very unpredictable in the sense that valuable information is tedious while access to them is commonly determined by luck. Second, movements in stock prices follow a random walk wherein forecasts and historical data will not be able to measure. Bearing this in mind, the three forms of EMH earlier presented are conceptually enforced in stock exchange transactions. Therefore, even with insider greater access to information, excessive returns will happened if inside information is subsequently mediated with luck.
The requirement of luck in every stock price investment is caused by the absence of penalty clause in capital market investments (Bernstein 1990). Capital markets are able to incur inefficient investing strategies without substantial loss and even hand potential gains although rarely. In contrast, product markets do not have the same operating environment. If a fast-food company does not choose strategies efficiently and decided to locate its new stores without regard to location characteristics (e.g. population and household income), there is a corresponding punishment such as low market share and unprofitable operations. Therefore, capital markets rely more on luck rather than governance structures and management strategies. This concept is attributed to the fact that the absence of punishment makes random strategy selection an indifferent action to the point of view of stock market analysts and participants.
Aside from the structure of the market being supportive to EMH, behavior of individuals particularly investors and investment managers can also provide similar EMH support (Shefrin & Statman 1985). First, the aversion of loss of some individuals is gained from distorted decisions. For example, an individual bought the share of a company at $5.00 each. In the event of falling price for five consecutive years, the investor will only sell his/ her stock investment once the price climbed to $5.00. This strategy, however, is sub-optimal as the person did not consider the time value of money, compensation to risks and also other transaction costs from the initial purchase and later selling. Second, people are often caught from the illusion of knowledge which a phenomena similar to belief on law of small numbers. That is, with only little sample information, the person fells that his observation is reliable to make a decision. As illustration, even if an investment analyst is able to outperform the market five consecutive times, it is not statistically possible that the sixth and later performance will be the same.
With EMH, the investing community affords two ways of outperforming the market; namely, pure luck or irrational decisions which eventually lead to pure luck. Accepting EMH that requires subsequent disregard from the opportunities to profit from mispriced stock prices can be stimulated by reminding the concept of invisible hand. In economics, invisible hand argues that individual benefits arising from an economic transaction will not be obvious and would only be classified as normal events because numerous individuals are doing the same thing. Thus, self-interests caused each of them to take advantage of inefficiencies in the economy. As increased competition persists, the tendency of initial participants is to exit the inefficient market because costs already outweigh the benefits. For prospective participants, engaging in similar activity will be less attractive that contributes to decreasing benefits attached to the market. For the remaining participants, they must confront competition and consequent costs with the belief that luck will struck them and that they have sufficient expertise to continue reliable investing strategies.
The Behavior, Abilities and the Environment of Insiders
Agency problem generally occurs when managers use their position to derive personal benefits which in turn reduce and impede the wealth-creation objectives of shareholders (Bebchuk & Fried 2003). There are several situations where the symptoms of agency problem is observed such as building an empire, inefficient investment programs and establishing platforms to prevent entrenchment of poorly performing managers. The Board-of-Directors are traditionally believed to minimize the agency problems as they are working in favor of shareholders. Specifically, they are the most active monitoring mechanism of shareholders against implications of agency problem. However, BOD also has their personal interest as well particularly to have an extended directorship position. There are various incentives of being so such as an attractive salary, prestige and important business connections.
The above situation increases the probability that collusion in implicit terms between CEOs and directors may accrue. This could be observed in give-and-take relationship. For example, the CEO has influence over nomination of directors while BOD has influence on designing CEO pay. Returning the favor from one side to the other is very eminent. Also, even if BOD and CEO are using an efficient and reliable bargaining platform, outsider criticisms would lead to undermining this feat. This is where the limits of optimal contracting are emphasized and the managerial power perspective to executive pay introduced (Bebchuk & Fried 2003). Due to several restrictions to executives to prevent a burgeoning agency problem, CEO and indeed directors and other line managers are using camouflage to overcome these restraints.
The tendency of managerial camouflage is a component of managerial opportunism. Managerial opportunism, like EMH, is a hypothesis that requires tests to ascertain validity. It states that managers are rational and that their superior information compared to the public leads them to a number of opportunities (Chalmers, Dann & Hanford 2001). Opportunism is taken as a negative condition because the primary role of managers as agents of shareholders is overtaken by managerial personal interests. Shareholders have several means to minimize the risks of an agency problem such as increasing monitoring systems to reduce asymmetrical information held by managers. Most of the time, however, costs of increased monitoring systems outweigh benefits. With this practice, it is apparent that managers have indeed superior information in both ends; namely, superior information against the public and superior information against the shareholders.
Individuals defined under EMH are bounded and biased rationality and that they participating in an intense capital market competition. On the contrary, insiders are competing based on almost complete information about their company stock and that competition with regards to their corporate stock are controllable by them. In effect, insiders view the risks of their own corporate stocks as totality where avoidance of risk is not only accessible but also open to maneuvering (Smith, 2000). In the hedge fund sector, investment managers are referred as absolute return managers which are characterized by several attributes. They undercut the importance of long-term returns in favor of short-term ones, they construct market trends rather than following them and they trade without reference to benchmarks. In similar fashion, insiders can also have their own niche where their superior qualities can be highlighted.
In some instances, insiders can reduce the restrictions of excessive returns imposed by EMH in an open market. In the case of Enron scandal, financial statements are poorly disclosed and largely lacking in major components (Thomas 2002). Before the scandal erupted, off-balance sheet (OBS) entities are tapped in order for the firm to have higher rating from rating agencies. Although OBS is currently regulated, the past management of Enron had used OBS to increase some important performance indicator. In effect, insiders are able to make the stock price of Enron excessively high. Eventually, the market unveiled the impacts of price escalation without basis of performance. That is, major leaders of Enron colluded and freeze corporate control in order to satisfy their personal interests. In this case, it is not hard to assume that the reason why managers acted illicitly is that they have substantial stock holdings that waited for a maximum price and right away rip-off profits if it emerges.
The ability of insiders to trade their own stocks legally provides them with the incentive to earn while the disincentive to cost of investors who do not have the same level of information. Increased oversight such as the recently enforced Sarbanes Oxley Act is able not only to reduce the excessive returns from information asymmetry but more importantly avoid corporate scandals. However, several studies about persistent outperformance of insiders against the market returns continuous to flourish. When managers or directors become significant shareholders, the motivation to use such position to obtain personal interests rises. Conflict of interest would persist as the former agents (i.e. CEO and managers) and monitoring platform (i.e. directors) are accomplishing their interests rather the interests of their principals. In general, the agency rule holds that shareholders are naturally risk-takers while the managers act as agents to help the former achieve their goals (Jensen & Meckling 1976).
There are two main factors how insiders can outperform the market thus rejecting the presence of EMH in strong-form. First is the information factor and the other is the influence factor. Accepting that capital market theory holds, insiders can have excessive returns simply because they have inside knowledge of how risky is the investment in their own corporate securities. Also, accepting that insiders are gamblers wherein their initial expected return is negative, they can influence the outcome through corporate control which makes them part of the casino administrators. In analogy, insiders are able to take part in the role of market trend initiators which is able to upgrade their initial position with regards to expected return as positive. Simply put, they are not just merely gamblers who are inclined to luck to be successful in outperforming the market. Indeed, their information and influence have functional merits in insider trading.
Hypothesis
From the conceptual framework above, there are three primary hypotheses that could be tested. The first two hypotheses are derived from the functional merits of insider information and corporate influence/ control while the third hypothesis wants to test whether the returns are persistent.
1. When insider buys the stocks of its own company, it will be able to outperform future stock price performance.
2. When insider sells the stocks of its own company, it will be able to underperform the future stock price performance.
3. The above hypotheses will persist in both short-run and long-run.
Methodology
The sample is selected listed companies whose shares are traded in the London Stock Exchange (LSE). There is an important requirement before an LSE firm will be qualified for random sampling. It must belong to the FTSE 100 which is the list of top-100 firms in terms of market capitalization. This is a crucial criterion in sample selection since it serves to simplify the study by taking firms who have substantial interest in the stock exchange. FTSE 100 comprises at least 80% of the capitalization of LSE which is to some extent is a practical yet major entities that take part the most number of LSE operational transactions. As the volume and the value of FTSE 100 stocks are relatively larger than the entire market, there is a larger opportunity and motivation for insider trading. Also, as the component firms under FTSE 100 are well-known and established global companies, information and influence gaps between insiders and common investors are substantial success factors.
Random sampling will be applied to FTSE 100 with the primary purpose of selecting thirty (30) samples randomly. This number is a statistical minimum of 30%. The reason of this selection is that there are a number of FTSE 100 listed firms that do not have insider trading activities. Reducing the samples to 30 firms is a key to avoid for being bias on how to select those firms that have data in insider trading. A scientific calculator with random selection capability will be used to select 30 samples from FTSE 100. The list of FTSE 100 will be encoded to excel spreadsheet alphabetically and will incur the row number of the spreadsheet. Once the scientific calculator is manipulated to select random numbers from 1-100, the firm that corresponds to scientific calculator computation will comprise the 30 samples.
Once the 30 samples are determined, Yahoo! Finance Website will be used to gather the needed data. There are two main data that must be extracted in the webpage. First is the incidence of insider trading which are organized in chronological order starting from the latest incident extending as far as incidences recorded in the year 2000. The second data is the stock price which corresponds to the date when insider transaction (e.g. buy and sell own corporate shares) takes place. In this respect, the one-month, 6-month and 12-month stock price performance is also collected. The preceding requirement will address stock price performance and its evaluation of how insider trading gains/ loss after those periods. Webpage data will be gathered manually using the Internet and the excel spreadsheet.
In analyzing the data, the functions used in excel spreadsheet will be used. The means and standard deviation of stock prices will be computed. The percentage change in the stock price will be determined using the formula: (Period Price – Insider Trading Price)/ Insider Trading Price and the value is multiplied with 100. As this will result to a single-average number, comparison to performance of a market index would be probable. FTSE 100 and FTSE All Share indices will be used to compare if insider trading in FTSE 100 results to underperformance or outperformance against the market. The presentation involves the use of percentages, bar charts and line graphs to reflect how the returns of insider trading in FTSE 100 perform against the market index.
Results and Findings
There are a total of thirty (30) firm samples derived from the FTSE 100. There is empty firm observation totaling five (5) randomly selected samples since they do not have records of insider trading data from the source. Firm sample observation with regards to insider trading is not similar as there are samples that exhibited high insider trading while there are also samples that have few insider trading. The requirement in order for the insider trading to be included in the data sample is that the trading must happened within March 5, 2006 and March 5, 2007. This enabled to have a reference point in post-12 month’s stock price performance up to March 5, 2008. There are a total of one hundred sixty one (161) firm observations which are classified as a buying and selling transaction having one hundred thirty one (131) stances and thirty (30) stances respectively. After the transaction date, the 1-month, 6-month and 12-month performance of the stocks are recorded. This aided in the computation of the percentage change of the succeeding stock prices to the initial purchase/ trading of stock by insiders.
Table 1
Table 1 shows the mean of price performance of stocks that are bought and sold by insiders compared to the performance of FTSE 100 Index. There are three dots in the line representing the 1-month, 6-month and 12-month percentage change of stock price after its acquisition or vending by the insider. The FTSE index represents the performance of the FTSE 100 stock prices in aggregate. As observed, insiders who bought the stocks underperform the market (i.e. FTSE 100) after the first month but outperformed the market in the sixth and twelfth month. On the other hand, those who sold their stocks outperformed the market in the first and twelfth month but underperformed it in the sixth month. It should be noted that outperforming (underperforming) the market in the buying scenario requires the purchased stock to have a higher (lower) percentage increase change in each period. The reverse is true for outperforming (underperforming) the market in the selling scenario wherein the sold stock must have a lower (higher) percentage change in each period.
Table 2
Tables 2 shows the standard deviation of buy and sell transactions. It is an important figure as it shows that the volatility of stock price changes for the samples are proportionally similar in both buying and selling stances. In effect, this could mean that the gains and losses of insiders have a definable boundary which translates to the possibility that they have a safety level when they are investing in their own company stock. With minimal volatility, say 10% to 50%, insiders have the advantage in assessing their risks compared to other investors that do not have the same safety level. Within the safety level, insiders could use their capabilities and financial depth to maneuver their investments into gains and avoid excessive risks.
Table 3
Table 3 shows a more reliable presentation than Table 1 because Table 3 is computed based on the median. This indicates that the effect of extreme values are controlled which preserves the representativeness of the computed data. In the 1-month period, buying insiders underperform the market but beat the market in both 6-month and 12-month period. As observed, however, Table 1 presents insiders as having a continuously increasing gains but Table 2 undermines this finding. For the selling insiders, they only outperformed the market after the first month and eventually unperformed it. Again, compared to Table 1, Table re-evaluated the accuracy of the computed data. It is in conclusion, therefore, that the 12-month period caused many insiders to loose money. This event is explicit in the 12-month median price change of selling insiders and implicit in the 12-month median price change of the buying insiders (e.g. due to sudden decrease in price).
Table 4
The number of outperformers and underperformers for buying insiders are presented in Table 4. After the first month, there are forty three (43) outperformers and eighty eight (88) underperformers. In the sixth and twelfth months, there are eighty (80) and seventy-nine (79) outperformers and fifty one (51) and fifty two (52) underperformers respectively. Generally, the number of short-term winners is smaller compared to the number of long-term winners. This shows that buying insiders who have a long-term investment view may found success in purchasing their own stocks. On the contrary, it should be noted that the short-term investors can also learn from them.
Table 5
The number of outperformers and underperformers for selling insiders are presented in Table 5. Relative to Table 4, Table 5 seems a reverse scenario wherein there are a greater number of insiders who ripped money from a short-run perspective. After the first month, there are twenty (20) outperformers and ten (10) underperformers. In the sixth and twelfth months, there are thirteen (13) and twelve (12) outperformers and seventeen (17) and eighteen (18) underperformers respectively. Generally, the number of long-term winners is smaller compared to the number of short-term winners. This shows that selling insiders who have a short-term investment view may found success in selling their own stocks.
Conclusion
Insider trading has been receiving continuous criticism in the investment world simply because insiders are generally agents of their own companies. As agents, it is the responsibility and benefit of an insider to influence the strategic direction of the firm, its operating decisions and to be in proximity with information whether past, present or future. There are studies that supports efficient market hypothesis in several stock exchanges but most of them are finding the weak and semi-strong form EMH. This tendency is apparent because the strong-form EMH includes historical data, public and private information as indifferent variables to obtain excess returns. The third variable which is private information seemingly is the force that is difficult to deal with. The UK Stock market has one of the largest and most modern financial environments in the world. In effect, this study is conducted to measure how this market could be influenced by insiders using London Stock Market and FTSE 100 as sample.
Using systematic methods, it is found that the when an insider bought a stock there is a tendency that he/ she can outperform the market in the long-term. There are several factors that disable the chance of buying insiders to earn substantially in the short-run which is largely affected by their “hiding-positions” to prevent speculation that they manipulating or exploiting their role in the company. In effect, to avoid criticisms, they will use their information as well as influence capabilities to reach their vested interests beyond the scope of public’s disapproval. This means that the public would allow insiders to rip money as long as the process is forgettable and not instant. If this is the case, buying insiders must send the message to the public that they are doing their job and will only rip-off benefits when the period of their effort elapse and positive outcomes emerge.
For the selling insider, there is minimal chance of long-run incentive because stock prices tended to rise in the long-run making the selling stance sub-optimal. However, the selling insider can benefit from a short-term investment. There are several factors affecting this tendency but one of the most obvious is that insiders that tend to sell their stocks strategically into the future can be dubbed as “not-working”. This means that the insider who is part of the management and directorship team is liable to shareholders and the public of not doing their best to support their company. Having a long-term view and underlying speculation from the selling insider that the company would be weaker in the future is bad for the business both in capital and product markets. This is the reason that many have lost when they are selling for the long-term. These reasons also support the fact that there are relatively small number of insiders who sold their stock compared to those who bought them.
Recommendation
For the stock price, an increase in expected dollar earnings of a firm with unchanged risk will increase its value while an increase in expected dollar earnings with lower risks will significantly increase its value (Bolten 2000 p. 4-10). Due to this scenario, higher-ranked common stocks are more preferred than lower-ranked stocks and the latter tends to be sold in favor of the former. The former is defined as those stocks with highest expected rate of return for the risk or the lowest risk for an expected rate of return. As earnings per share (EPS) indicates the dollar return for every stock an investor purchased, it is one of the most items in the firm’s financial information that receives highest interests. For its part, the firm should solidify its claim of having high-ranked stocks to be able to compete for the limited available capital in the economy. As debt financing is more risky than equity financing (since the firm is obligated to pay debts even minimal or no profits is obtained), this task of the firm should be convincing.
Although corporate earnings have positive relationship with stock price (Bolten 2000 p. 4-10) (that is, the greater earnings are, the higher stock price will be), external forces both political and economic in nature would barred the firm from optimal realization of such relationship. In effect, being inclined or parallel with economic indicators is as crucial as internally generated earnings. One indication of this is that expected earnings should exceed interest rate of government bond to be able to be competitive. Another is that it should flow consistently with changes in interest rate, inflation and economic activity. This will make the firm’s investors to avoid unguided speculation when making investment decisions. It is a well-known dogma that no participant in a stock exchange can control the entire trend of stocks and so the consensus counts. And where will a rational firm/ investor/ government base their decisions? Of course, on what is really happening to the economy with small number of them speculating for short-term gains, that is, a mere buy and sell strategy.
Too much inflation (hyperinflation) has negative effect on stock price which can either be stimulated by pull and/or push consumer/ producer effects. To dispute this, common stocks are viewed as inflation hedgers (Bolten 2000 p. 56) as they can easily maneuver the cost of firm’s goods to follow inflation in the cost of production. Generally, the adverse inflationary effects on stock price is rather of short-term basis while the long-run inflationary functions of common stocks can be derived by an investor who is willing to place his investment longer in the hands of the firm.
There are at least three types of traders/ investors in the stock market (Reuters 1964). This will serve as a guide for every trading/ investment strategy. For portfolio managers, one profitable trading strategy especially for portfolio managers is top-down stock strategy wherein the economic and market environments are analyzed before making a decision. Bottom-up approach emphasizes financial analysis of a firm’s data including comparison of stock performance against its competitors. For technical traders, there is also a technique to forecasts stock price movements by using previous charts to identify trends and there signals of actually happening including their impact. Hedging and arbitraging strategies are also used to aid in analysis. For sales traders, another is the strategy that aims to determine the best price by having knowledge of trading partners and relative prices to identify who is liquid in the market and exploit such identification.
Bibliography
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London Stock Exchange (LSE) Website (2007). Cited March 6, 2008 in <http://www.londonstockexchange.com>
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