Should you trust directors’ judgement?

We might be heading for a stockmarket collapse, but it seems no one told the management of Britain's listed companies. Directors have bought up a total of £54m of their own shares in the first six months of this year, compared with £65m for the whole of 2006.

So do they know something we don't? After all, "insiders' behaviour is predictive", says Nejat Seyhun, a finance professor at the University of Michigan. Yet had you done exactly as three of the biggest spenders over the past year Frits Seegers, head of global retail banking at Barclays; Andy Hornsby, CEO at HBoS; and Charles Dunstone, founder of Carphone Warehouse and a non-executive director at HBoS, you would be down around £1.1m, or about 41%.

Three deals is hardly a rigorous sample. But there's plenty more evidence that you can't always trust a director's judgement when it comes to buying shares. Right after the credit crunch reared its head last August, "insiders were buying at a level we had not seen in close to two decades", says Ben Silverman, head of research at Insiderscore. But while the S&P 500 rallied from around 1,406 to 1,554 by mid-October, it is now down to around 1,330, a drop of 14% from that peak. Then there's the Claymore/Sabrient Insider ETF (AMEX:NFO), which tracks an index of 100 US-listed shares selected (from around 6,000) largely on the strength of which companies show "a trend of insider buying" the exchange-traded fund has fallen by around 11% this year.

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Even so, "directors have generally shown an ability to time the market", says the FT's Neil Hume. The key is not to copy them blindly. Share deals can be driven by motives other than performance selling to raise the cash to pay school fees, for example, or buying because options granted as part of a remuneration package are due to expire. So, when are directors' deals what fund manager James Ridgewell at New Star describes as "a useful extra tick in the box", rather than red herrings?

Look at the buy-and-sell ratio

Khuram Chaudhry of Merrill Lynch says this ratio is "one of the best indicators of market sentiment". For example, directors sent out a clear buy signal in October 1998 when the market bottomed after the Russian default and the ratio hit 12:1 in other words, for every director selling, 12 were buying. The ratio hit 10:1 in March 2003, at the start of the last four-year bull run for equities. Just now it stands at just 4:1, suggesting executives are "unsure about the direction of the market". So you should be wary of buying, too.

Also look at when a director trades, says Tom Howard at Knox D'Arcy. The run-up to results is usually a reliable sign that they are motivated by profit. And you should pay more attention to deals by full-time main board executives. They are a better guide than part-time non-executives, whose purchases "tend to perform badly".

Look for underperforming stocks

Directors' purchases that do well tend, "unsurprisingly", to be in firms that have been underperforming both their sector and the wider market, as Morgan Stanley's Graham Secker notes. The best bets are shares that have done "neither very well nor very badly" in the six months before a director's purchase. A review of 3,500 directors' purchases over the past two years showed this "middle third" went on to beat the market over 12 months by 4.2% on average, compared with 2.6% for the top third and -3.4% for the laggards. However, he warns, a purchase by a director "is not an immediate signal of near-term good performance". It takes an average of another 12 months to achieve a positive relative performance. Directors tend to "get in before things get good", as Christian Magoon, Claymore Securities president, tells Forbes.

Buy expensive, rather than cheap

This approach flies in the face of a "natural inclination to buy value", says Secker. Yet his study shows that stocks bought by directors that also had a price-to-earnings ratio within the top quartile of the most expensive FTSE AllShare stocks subsequently did better than those that were cheap. However, he concedes this could be in part because we may be in one of only three periods in the past 30 years where "a valuation approach has underperformed". In short, a low p/e ratio in today's market is a sign that a firm is struggling, not that it is an underrated bargain.

So, what to buy?

Despite a rocky 2008 so far, the Claymore/Sabrient Insider ETF has managed to rise 9.4% since its launch in September 2006, against 2.8% for the S&P Midcap 400. Its top holdings include some MoneyWeek energy sector favourites, such as solar firms First Solar (NASDAQ:FSLR), SunPower (NASDAQ:SPWR) and natural gas group Chesapeake Energy (NYSE:CHK). Secker currently tips mining giant Xstrata (LSE:XTA.L) and care homes group Southern Cross (LSE:SCHE).