FOOL SCHOOL
How Useful Are Directors' Dealings?

August 24, 2005

One popular investing technique is to follow the lead of directors when they buy or sell shares in their own company. But does it make any sense to do this? There is certainly a compelling logic to the idea. If anyone knows about the company's prospects then it should be the directors.

However, directors are only allowed to deal at certain times of the year. They cannot deal in what is known as a "close period".

Close Periods

According to the rules of the London Stock Exchange directors are not allowed to deal in the two months prior to a half-year or full-year earnings announcement or, if shorter, the time between the period end and the day of the announcement. If the company reports quarterly then a limit of one month applies for all but the company's full year results. This restricted period is known as the close period.

So if a company's year-end was December 31 and it released its results on 15 March then its directors would be able to buy or sell shares up to 15 Jan. If it released its results on February 15 they would be able to deal up to December 31.

Directors are also not supposed to deal when any unpublished price sensitive information exists that is due to be released in the near future. "Price sensitive information" simply means any information that may have a significant impact on the share price, such as a statement that trading was below expectations or that a bid approach has been received.

So given these restrictions is it still worth following the directors? The logic still holds. Although directors cannot trade when the share price might move violently in the short-term they can still deal with knowledge of prospects for the longer term.

Buys better signals than sells

Some punters put more weight on directors buying shares than those selling. The theory goes that a director could be selling for a number of reasons. If the majority of a director's wealth as well as their salary is tied to one company then it makes sense to reduce their exposure. A director may also sell shares because they need the cash, to meet a tax liability for example. But as directors are normally so enthusiastic about their companies' prospects, any reasonably sizeable sale should at least raise a warning flag that something may be amiss.

A buy is supposedly a stronger signal because you will only buy when you believe the shares will rise. That's not always true. Many directors buy shares to display confidence in the company's prospects. The two most common examples of this are chief executives when they are first appointed and directors trying to reassure investors after a sharp fall in the share price. If you've ever read many company reports you'll be painfully aware that the confidence of directors can often be misplaced.

It's also worth remembering that just because a director knows a lot about their company it does not necessary follow that they know whether it is a good investment at that time. They could just be a bit of an idiot when it comes to investing!

The Cluster Theory

To get over these hurdles some say you should concentrate on situations where large numbers of directors buy or sell over a short period of time. This makes a lot more sense. One director could just be an idiot but if the entire Board is full of idiots then it is unlikely that the company will be around for that long. But on the sell side however it is possible that more than one director could be selling to fund tax liabilities that have arisen from share options.

A further sieve is looking to see how significant the buy or sell is compared to the director's total holding. The chairman buying or selling 10,000 shares compared to a total holding of 10m doesn't really indicate anything. An impoverished, 30-year-old finance director adding 50,000 shares to his existing 10,000 is a much more positive signal. But don't forget the idiot caveat.

Where To Find Directors' Dealings

Whenever a director buys or sells any shares in their company, it is obliged to make a regulatory announcement. These news releases are available on many brokers' sites and on sites like UK-Wire. The announcement has to contain the date of the transaction, the number of shares, whether it was a purchase or sale, and the director's holding following the transaction. Companies also have to disclose how many shares and options each director has in their annual reports. You can also find weekly roundups of all deals in Saturday's Financial Times or the Investors Chronicle.

Less Theory, More Practice

Theory is fine but is there any evidence that this actually works? Some studies that have been carried out suggest it does not. A glance at James P.O'Shaughnessy's exhaustive work on the merits of various investing methods, What Works On Wall Street shows that this technique did not even merit a mention.

So it looks like investors should not put faith too much in directors' dealings, unless they want to use it as just one small part of their overall analysis just to provide an extra comfort blanket