Should you follow Directors?

Many investors believe it's worth keeping an eye on directors buying and selling shares in their own companies.

The reason is - if a director is buying a lot of shares it's assumed he or she has some confidence in the future of the company - and it might be worth buying in.

Conversely if a director is dumping shares, perhaps the confidence is simply not there and one has to be careful.

Generally, directors are allowed to buy and sell shares in their own companies, but they are not allowed to trade in shares of their company in the six weeks preceding a results announcement (this is known as the ‘closed' period).

So you will often find directors buying or selling shares on the day of results or one or two days afterwards.

Many investors believe that by following buys or sales by directors they can make money. That is by buying into companies where directors are buying and selling or "shorting" (betting on them to go down) when directors are selling.

Of course just because a director buys it does not necessarily mean the shares are going to rise. You have to examine the buys and sells in tandem with doing proper research into the companies. Following directors' dealings slavishly in my opinion may not lead you to stock market millions! 

  The problem is directors are usually rather enthusiastic about their companies and so might buy even if the shares are actually overvalued. Sometimes directors simply buy to try and prop up the price of their company if the share price has been falling.

For example, the infamous Robert Maxwell was busy buying shares in his own company, even though he must have known the company was in deep trouble.

Directors know by buying their shares there will be an announcement and that could cause investors to buy in. The key, I believe to working out whether a director buy or sell is worth following or not, is the amount of shares bought or sold.

If they are buying a huge amount then I am more interested. Or if they are buying a lot of shares in relation to their current holding. It is always worth looking at how many shares they already hold to put their buy or sell into context.

For example, if a CEO of a company sells one million shares, does that mean it is time to follow suit?

Not necessarily, if, say, the director still owns fifteen million shares. He might just have needed the money to buy a better house! But if he'd sold half his stake, I might get a bit worried.

It's the same with buys - always check the amount of shares a director is buying and selling against the amounts he or she holds. The bigger the proportion of shares bought compared to the amount owned is what you should look at carefully.

 It can sometimes be a good sign if a director buys, say, £20,000 worth of shares if they only already hold a small amount. Not all directors are wealthy, and £20,000 might be quite a big investment for a director of a smaller company.

It is not always a good idea to just follow directors' buying.

 Here's an example of when simply following a director's buy would have caused you to lose ALL your money.

On July 16th 2006 a director of Homebuy bought 25,000 shares in the company and another one bought 100,000 shares - that's nearly £290,000 worth between them.

Incredibly, just a few days later on August 10th, the shares were suspended "Pending clarification of financial position". And just one month later, the company called in administrators and effectively went bust.

Shareholders never got a penny back. Those directors lost all their money. A salutary lesson in making sure you do proper research and not just follow dealings. The company was in fact heavily in debt and the banks pulled the plug. I had seen and was encouraged by the buys but because I had researched the company properly I did not buy because of the huge debt.

 But here's a different story. On June 7th this year a director of recruitment group Harvey Nash bought 10,000 shares to add to his holding of 22,000. He bought at 79p. Just a couple of weeks later the shares had soared 15% to 92p. You can see here the amount bought was just under £8,000. So not a huge amount - but he was adding around a third more to his holdings.

 To sum up, watching directors' dealings is something every investor should do. And sometimes seeing a deal can lead you to examine a new company that you haven't come across before.

But you should never slavishly follow a deal - there is no substitute for doing your own research into a company and use a director deal as good "bonus" information. Happy hunting!