Should you copy directors' deals?

In theory, company directors should know their business and be able to gauge its prospects better than anyone else.

So it's no wonder that many investors keep a keen eye on directors' buying and selling (recent transactions are listed in our Director Dealings section) and often follow their lead. But does this strategy work?

Studies suggest it can help predict returns. According to UK-based website Directorsdeals.com, which has explored transactions between 1999 and 2003, significant buying by directors was followed by an average rise of 23.5% in the year after the purchase. Significant selling was followed by an average drop of 15.5%.

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This agrees with the adage that buys are more useful than sells, as there can be various reasons behind a sale. Directors may sell to raise cash for a tax liability or a divorce settlement, for instance, whereas they are only likely to buy if they think that the shares are set to rise.

Fool.co.uk suggests looking out for clusters of directors selling or buying for added reassurance. A further sieve' is to assess how significant the trade is compared to the director's holding. Is the director suddenly snapping up a hefty stake, or merely topping up a large holding?

Examine whether directors at the core of the business, such as the CEO, are doing the buying, says Ellen Kelleher in the FT, and check that the person is spending their own money rather than participating in a pay scheme. The trading of options "is not a particularly telling indicator of sentiment".

But none of these safeguards can guarantee that a particular director has his timing right. So it's worth knowing who the successful directors are. Directorsdeals.com did a study for the FT to identify successful directors over the past six years and found that Marks & Spencer chairman Paul Myners (pictured) was particularly striking: his shares rose by 169%. Other names to watch include the LSE's Clara Furse and Sir David John of Premier Oil.

But directors' dealings are hardly an exact science and as a basis for investing they are no substitute for examining a share's fundamentals and the economic climate. As James Ridgewell of New Star puts it, they are simply "an extra tick in the box".