Smart Money, Killer Stocks

When asked in a recent Motley Fool interview whether he intentionally seeks out family-run businesses, small-cap guru Charlie Dreifus was revealing. It turns out that Dreifus doesn't screen for insider ownership when stocking his recently closed Royce Special Equity Fund. To his mind, insider ownership "explains why they often make" his screens. That's no minor distinction, and it's absolutely key to Hidden Gems investing.

Cause, symptom, or side effect?
Just this year, the University of Pittsburgh determined that surgery patients recovering in rooms with lots of natural light required less pain medication, resulting in a 21% drop in drug costs. This finding -- that patients fare better in bright, sunlit rooms -- was hailed as seminal for the health-care, insurance, and pharmaceutical industries. We're not doctors, but doesn't this strike any of you as kind of obvious?

Like medicine, investing is a very serious business. There's as much art to it as science, and we all have hunches and feelings. But wherever possible, our duty is to bear such things out -- if not quantitatively, then at least objectively. Fortunately, when it comes to the relationship between insider ownership and company performance, the heavy lifting has been done. And for all the perceived controversy and doubt, the evidence to date is remarkably one-sided.

Case in point: Drawing on a broad sample of U.S. stocks, a University of Vienna study recently asserted the "unambiguously positive" influence on company performance of what the authors deemed the "wealth effect of insider ownership." There is an important caveat, which we'll address shortly, but this conclusion that insider ownership is positively -- if not linearly -- correlated with company performance supports a body of work dating back to a seminal (there's that word again) paper published in 1988.

Give it to me straight
The debate raging in academia -- and it rages on Wall Street, too -- is whether this is just good to know, or whether we as investors stand to profit from this knowledge. At the extreme, one might simply buy a basket of stocks screened exclusively for high insider ownership. We're still not doctors, but if you even consider that trick, we won't hesitate to produce the smelling salts. Academics are wonders at objectivity and weighing cause and effect, but getting to the heart of things is up to us artsy practitioners.

So back to Charlie Dreifus, who says, "A lot of the companies that I end up buying have a family that owns 20%-40%.... They tend to have conservative financials. When a family's net worth resides in a business, they are less prone to give it away in terms of stock options or other things that negate their own financial interest." As usual, Charlie Brown said it best: "That's it!"

The outperformance of Dreifus' portfolio and our own hidden gems can't be traced to some technical factor stemming from high insider ownership (say a limited float or a lack of selling into downdrafts). They outperform because directors and managers and family owners behave differently when they have direct stakes in the success, reputation, and sustainability of the underlying business. And while this coveted breed of stakeholding can arise out of kinship, nostalgia, association, and -- who knows -- even human pride and decency, more often than not, the culprit is a clear financial stake.

What are my options?
You're probably thinking, "Those crooks at Enron and WorldCom couldn't have sold so much stock if they weren't major stakeholders to begin with." In fact, those two very different cases illustrate two critical points. First, huge options packages -- and, to a lesser extent, grants of restricted stock -- do not have the same effect of aligning the interests of shareholders and management.

In fact, by diverting the focus from long-term sustainability to near-term stock price, both can have the precise opposite effect, especially once a culture comes to regard insider selling as cashing a paycheck. So be careful when checking a proxy, annual report, or even such popular data sites as Yahoo! (Nasdaq: YHOO  ) for insider holdings. Always go to the footnotes to confirm what portion of an insider's total holdings is made up of options.

As for the Bernie Ebbers/WorldCom exception -- well, that's a bit trickier. The Vienna study echoes others in noting something in the relationship between insider holdings and company performance -- namely, that it's not linear. Without delving into excessive detail, the studies imply that when measured as a percentage of the total company, insider ownership beyond a certain level can lead to what's known as "management entrenchment," and often to underperformance. If that conjures images of despots and crooked bureaucracies, it should.

Wait just a minute there
Now, you're probably wondering just how Bernie Ebbers' WorldCom and the Rigas family's Adelphia Communications differ from Gates and Allen's Microsoft (Nasdaq: MSFT  ) , Michael Dell's Dell (Nasdaq: DELL  ) , or Larry Ellison's Oracle (Nasdaq: ORCL  ) . Weren't they all true hidden gems at one point? Weren't all once-story-stock miracles led by charismatic leaders with serious ownership stakes?

There's no easy answer here. One must listen closely to the leaders, weigh their words and actions, and keep a close eye on the business. The difference between a despot and a visionary does not show up in the financials or on a simple screen -- but do watch that insider selling! Not all insider selling is bad, but we don't want to see massive reductions in common stock positions, and we really don't want to see insiders selling into price weakness or bad markets.

Fortunately, our quest for undiscovered gems covers us a bit on this. After all, WorldCom, Adelphia, Enron, and even Tyco (NYSE: TYC  ) share something in common beyond shaky management. All were bilked by their charges as mature businesses with high-flying stocks. They'd grown out of "gemhood" years ago, and none could be called hidden. Academics and practitioners agree: Insider ownership matters across the spectrum, but all the more so with smaller companies and small-cap stocks.

Bringing it all home
It's been fashionable at times for Wall Street types to scoff at insider ownership and the perils of excessive reliance on executive salaries and options-based compensation. But having talked with money managers -- some heavy hitters, some hidden gems themselves -- we know that it matters to them, as it matters to us. Informed investors prefer that the hand at the helm belong to one whose livelihood is securely in the boat. They might not always be the right ones, but you can bet their decisions will be made with the long-term success of the firm in mind.

If you want more evidence of the power of insider ownership, lend an ear to our interview with Paul Toms, CEO of Hooker Furniture. Or check out all our chats with the dedicated, ownership-driven CEOs of our Hidden Gems recommendations. (You can read the transcripts right now by taking a free trial.)

Just see if most don't remind you a bit of Sam Walton, Dave Thomas, or Warren Buffett. Hold on a minute -- are we confusing these gems with the likes of Wal-Mart (NYSE: WMT  ) , Wendy's (NYSE: WEN  ) , or Berkshire Hathaway (NYSE: BRKA  ) , (NYSE: BRK.B  ) ? Hardly. Then again, we're looking for the next home run stock.

Take a free trial ofMotley Fool Hidden Gemsand watch Paul Elliott toil as Tom Gardner's editor. He doesn't own any of the stocks mentioned. The Motley Fool is investors writingfor investors.


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