Imagine a company CEO in his plush office. There are renowned artists adorning the walls and a beautiful view across the City skyline. It's a multi-million-pound turnover corporation. And this guy's got the company trade secrets at his finger tips. He knows intimately how well, or badly the business is doing.
Now if anybody knows whether his company's shares are a buy or a sell, it's surely the CEO. If this guy is buying, or selling, surely you'd do well to do the same.
And because company director share dealings are published by the stock exchange, you can find out exactly how he's trading.
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But be very careful. A lot of investors make serious errors on the back of misreading director dealings. You really need to know what you are looking for.
There are four things I look for when a CEO buys up a tranche of his own company stock. And if you are aware of the pitfalls, these four signals could prove seriously useful - giving you the inside track on some of the biggest stocks in the City.
Four buy signals that give the CEO away
Directors know full-well that there's a significant group of investors that scrutinize their share-dealings.
They know that a purchase can be like a free ad that can help give their shares a fillip. In fact, I've been to a few AGMs where shareholders have begged directors to buy some stock just to help give the shares a little boost.
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These small 'free ads' aren't going to tell us a lot about where the price is ultimately going. I'd say that this sort of manipulation can actually be bad for a stock as 'the buy is a lie'. I'm not interested in a stock that needs to be massaged upwards. And anyway, if a director is prepared to deceive, then what else might he be doing to help bolster the share price in the short term?
What we actually want is a genuine and significant trade. I look for four things. First I'm looking for a chunky buy relative to the size of the director's salary. Second I look at his overall holding to see how much faith he really has in the business.
Then I look at the series of recent dealings. A flurry of buys from several directors is sometimes a credible signal to buy.
Finally I keep a close eye on the directors' options. Many directors get options to buy shares as part of their pay package. Options allow directors to buy shares at a knock-down price, so don't read too much into these buys. I'm only interested if they're buying at the same price that I have to pay.
And if they are selling, I am just as careful to asess the credibility of the trade.
A sale doesn't always mean you should follow
Directors often have a good reason for selling. Founders of a business usually have a sizeable shareholding right from the start. And it's not unreasonable for them to want to dilute it over time. Especially if the company has been doing well and the share price has been growing nicely.
The director will want to diversify his assets. Remember, his job is tied up with the business, so if his savings are too, he's quite exposed if something goes wrong. And if he's selling a small part of his holding to make the most of a capital gains tax allowance, then I really wouldn't read anything into that at all.
As with share purchases, it's all to do with how 'significant' the trade is. If a director is bailing out of a large position and there's no good reason for it (like an expensive divorce, or an unexpected tax bill) I'd consider following him out too.
You need to scrutinise your directors dealings
At MoneyWeek, wehave a dedicated Director Dealings area on our website which can give you some useful information.
If I'm looking at opening a new position, I'll take a close look at how directors have been trading. It's all part of the story. I'll do some investigating as part of my due diligence before I open the trade.
In my experience, director share dealing is especially important for smaller companies. In small stocks, the directors really do have a much better idea of what's going on than any analyst, or City pro.
This article was first published in the free investment email The Right side. Sign up to TheRightSide here.
Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.
Managing Editor: Theo Casey. The Right Side is issued by MoneyWeek Ltd. MoneyWeek Ltd is authorised and regulated by the Financial Services Authority. FSA No 509798. https://www.fsa.gov.uk/register/home.do
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