Interpreting Directors’ Dealings

On 22 March 2021, executives in Delta Corporation and Innscor Africa bought shares in their respective companies. The two stocks subsequently posted gains in their share price in the seven days that followed the stock purchases. Innscor moved from ZWL$68.51 per share on the 22nd of March to ZWL$74.97 on the 29th of March 2021. Similarly, Delta went up 20.1% from ZWL$39.79 per share on the 22nd of March to ZWL$47.78 on the 29th of March 2021. This phenomenon is common in equity markets and this is usually interpreted as a positive sign by various economic and finance theories. This article focuses on the agency theory and information asymmetry.

Directors’ dealings often address the principal-agent problem that exists in businesses that are not run by their owners. The principal-agent problem stems from the differing interests between company shareholders (the principal) and company management (the agents). Company shareholders typically want to maximize profits and returns on their investments whereas management typically wants to increase their compensation for their efforts in the day-to-day of the business. The principal-agent problem typically manifests when agents push their own interests ahead of the principal’s interests. This includes, but not limited to,

• management signing off on a big project that gives them more authority or prestige instead of pursuing something else that could maximize shareholder value,
• management taking on low-risk projects which, in turn, offer low returns to shareholders out of fear that they could lose their jobs if they opt for high-risk/high-reward projects, and
• hindering company takeover bids that unlock shareholder value because they usually result in loss of senior management jobs post the merger.

This problem was initially resolved by having a board of directors whose duty was to ensure that the principal-agent problem was contained. However, this also came with more conflicts of interests. First is Tier-I conflicts which occur between a board member and the company. Board members usually hold significant influence in the direction of the company, and therein lies a board member’s ability to align a company’s interests with his or her personal interests. Tier-II conflicts arise when a board member’s duty of loyalty to stakeholders or the company is compromised. This would happen when certain board members exercise influence over the others through compensation, favors, or even a relationship. Tier-III conflict emerges when the interests of stakeholder groups are not appropriately balanced. This type of conflict has become critical in recent times amid increased focus on previously marginalized stakeholders in business such as people of color and women.

The myriad of conflicts then gave rise to compensating management with a portion of the company and making them shareholders. This method of conflict resolution aptly aligns the interests of shareholders and those of management, and it reduces the principal-agent problem. The recent directors’ dealings therefore serve as an assurance that the company executives’ interests remain aligned with the interests of the shareholders.

The second theory is based on information asymmetry. In this context, information asymmetry occurs when one party (management) holds more information about a company more than another party (the shareholder). Company managers typically have a better idea of a company’s future potential given that they have the expertise and executive powers to move the company in the direction that they deem most beneficial to various stakeholders. As a result, actions by company management are construed as signals that can be material to investors of that company. When a director deals in their own shares, it sends positive signals to investors. Most investors feel assured of their investment in a company if a director uses their hard-earned money to invest in their own company. In some cases, this is a factor that tips unsure investors into buying a company’s stock. 

However, if a director sells their shares, one should not be hasty and conclude that the business is headed for rough waters. Some companies compensate their executives using both cash and equity. A global survey conducted by the Advisory Board Architects (ABA) found that 15% of private company boards paid no compensation, 25% paid only cash, 43% only equity, and 17% paid cash and equity. The survey also found that the boards with the most impact were paid in both cash and equity. While this survey was not in the sphere of listed equities, it sheds lights on the case for compensating executives in both equities and stocks. Some of the executives that are compensated in this way often sell the equities to cash in their rewards. The sale of equities by a director in this case should not be construed as a negative signal on the company’s future earnings potential.

These theories have faced criticism over the years, with some studies showing inconclusive evidence. As a result, investors should not depend on directors’ dealings only when making investment decisions. Rather, directors’ dealings should be used to complement the due diligence process. Fundamental analysis remains an important part of due diligence that cannot be substituted by these theories. In addition, directors’ dealings are infrequent events that do not occur periodically, as is the case with the publication of full-year or half-year financial reports. Therefore, one cannot use this as the first point of investment analysis.

Delta Corporation and Innscor Africa both have strong fundamentals that support the above-mentioned theories. Delta Corporation offers products that match prices with customers’ differing disposable incomes. The brewer offers premium beer (e.g Castle Lite, Miller’s, Flying Fish and Peroni) for the affluent customer, mainstream beer (Castle Lager and Lion Lager) for the middle-income earner, and economic beer (Eagle Lager and Chibuku Super) for the low-income earner. In addition, Delta Corporation is the market leader in the supply of both alcoholic and non-alcoholic beverages in the country and it has good regional operations in South Africa and Zambia. Innscor Africa’s comprehensive vertical integration often drives the business’ rich margins and less volatile earnings. The business is also a market leader in most of the sub-sectors in the fast-moving consumer goods industry. Both Delta Corporation and Innscor Africa are financially sound and their products are largely defensive in nature, which means that they often have better odds at weathering long periods of economic downturns such as the COVID-19 pandemic.