A new investment system with 169% return over seven years

Getting rich without having to do any hard graft has always been an attractive notion, and one outfit that intends to give it a try is Knox D'Arcy Investment Management.

Actually, I am doing them a disservice because Knox D'Arcy, with the assistance of academics from the Universities of Bristol and Exeter, spent three years devising a new system.

In back testing, it achieved a total return of 169% over the past seven years, a massive improvement on the 28% return delivered by the FTSE Index of small companies.

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The secret is nothing new, and is based on following the lead given by directors. Directors in a company know what is going on better than anyone, so if they are buying shares it should be safe to assume that good news lies around the next corner.

Where Knox D'Arcy has advanced the matter is through a three-year study that has analysed 187,000 directors' trades, and sorted out the worthwhile signals from those that count for less. For instance if directors exercise options or buy a token number of shares on appointment to the board this is less significant than when a director gets his cheque book out and buys a slug of shares in the market.

Directors' dealings: a continuing system?

Knox D'Arcy has discovered a few other things. For instance that buying by executive directors is more significant than buying by non-executives. And that cluster trading' where several directors buy at once is more significant than purchases made by one individual.

Now Knox D'Arcy has refined its criteria and intends to put its conclusions into practice by converting the underperforming Eaglet Investment Trust (EIN) into the Directors' Dealing Investment Trust. It will be interesting to see how it performs, and whether it can counter one frustrating feature of the stock market - that no sooner has a system been found to deliver excess returns, than it somehow stops doing so.

This phenomenon has been associated with a general cyclicality of returns and a tendency of investors to jump on any bandwagon thus driving up values to such an extent that a continuation of excess returns becomes impossible. If there is failsafe way of making good money it is hard to keep it a secret. Imitators soon latch on and spoil the party.

Directors' dealings: will the criteria work?

There are one or two other things that investors should be concerned about. First of all, will the Investment Trust be able to buy shares at or at least close to the price paid by directors? I understand that the calculation of past returns makes some allowance for this. All the same, and although Knox D'Arcy will stick to companies with a market value of at least £25m, trading liquidity in small stocks is not always the best, and if other players in the market see Knox D'Arcy coming they will not sell them any shares lightly.

And the size of the fund is likely to be close to £100m, meaning that even if it holds as many as four hundred shares it must invest £250,000 into each at an attractive price. Will Knox D'Arcy be able to find a sufficient number of candidates for investment or will it have to lower its criteria in order to get the money invested?

Directors' dealings: private investors be warned

These are problems for the fund manager. But for private investors Knox D'Arcy's research has thrown up some interesting conclusions, not least of which is the fact that a pursuit of directors' dealings is far from a dead cert. While more than half of the shares that give Knox DArcy's buy signals do outperform the market, the rest do not. But while the former go on to outperform the market by 40% the losers only underperform by 30%. So if you can buy enough of these shares the odds should be in your favour, but if you just follow the occasional signal it is quite likely to be misleading.

A second conclusion is that the effect is stronger with small companies. This is probably because there is a great deal more known information' about large companies. They are closely analysed, and one item of evidence in the form of a director's share purchase will not make a great deal of difference to the City's perception of the company. Small companies, though, are quite obscure. Not much is known about them. So directors' dealings can add materially to the sum of information, and prompt a closer examination of the investment case.

Entrepreneurs are by definition optimistic. And they can be so attached to their own business that sometimes they cannot see the wider picture. But still, when they put their money where their mouth is, then investors should pay attention. I always do!

This article is taken from Tom Bulford's free daily email Penny Sleuth'.