How I Find Great Stocks

At the Million Dollar Portfolio annual meeting last year, I made what some considered to be a bold statement. But after the stock market meltdown, my confidence in that statement is stronger than ever.

The only metric I need
While there are plenty of key metrics you can use to evaluate a company's worth, I believe that the vast majority of investors would see a boost in their returns by focusing on just one of those metrics. It's not the company's revenue growth rate, price-to-earnings ratio, or free cash flow. In fact, it's very rare that you will see this metric included in research reports or mentioned by the mainstream financial media. But I have made some of my biggest investing mistakes by not paying closer attention to this metric (more on those in a moment), and I have made some of the greatest investing decisions of my life by focusing on it.

The metric is straightforward, easy to find (just look at a company's 14A filing), and it doesn't require any math or investing experience to interpret. You'd be amazed by how closely correlated it is with stock market success, and yet it is still overlooked by the majority of investors. You MAY have guessed it ... my metric of choice is insider ownership.

Why this metric makes you money
Simply put, insider ownership measures the percentage of a company's stock that key executives own. Generally speaking, the higher this figure, the better. Founders and managers with high levels of ownership have their own wealth riding on the company's performance. They are doing everything they can to increase the long-term value of their stock -- no, of your stock.

Take Ray Dolby, founder and CEO of Dolby Laboratories (NYSE: DLB  ) , the market leader in audio enhancement technology. Ray owns over 60 million Dolby shares -- or roughly 53% of the company. In addition to that substantial ownership position, Ray's surname is stamped on every product the company produces. You can rest assured that every decision he makes will support the long-term viability of the Dolby brand and the interests of his shareholders.

One size does not fit all
As a general rule of thumb, I like to see CEOs of small-cap companies own at least 5% to 10% of the outstanding shares. Of course, it's far easier for Carlos Aguero to own 10% of tiny Metalico (AMEX: MEA  ) than it is for John Chambers to own 10% of $132 billion behemoth Cisco Systems (Nasdaq: CSCO  ) . That's why for large-cap companies, I look for CEOs whose ownership position represents a meaningful percentage of their net worth -- let's say $10 million or more.

Good, but not foolproof
Unfortunately, a large ownership stake is not enough to guarantee a company's success. In fact, my own investing record has been scarred by placing too much trust in an executive's ownership position.

In 2004, I recommended DHB Industries, a supplier of protective armor to the military and law enforcement agencies. I was encouraged by the surging demand for the company's Interceptor Body Armor due to the war in Iraq, as well as CEO David H. Brooks' 40% ownership stake. However, it soon became clear that David H. Brooks was only interested in the well-being of one shareholder -- himself.

In addition to allegedly using company funds to pay for personal expenses, including cosmetic surgeries and vacations, Brooks has also been accused of manipulating DHB's financials to inflate the stock price, then cashing out his sizeable ownership stake. While his shareholders dealt with the messy aftermath, Brooks used part of the proceeds to hire Aerosmith, 50 Cent, and Kenny G (Kenny G?) to play at his daughter's bat mitzvah. Adding injury to insult, the company's body armor failed ballistics tests and was ultimately recalled.

That's why we use more than one metric
As my DHB example illustrates, sometimes relying on the insider ownership metric can lead us astray.

But make no mistake -- while you might suffer the occasional fraud or incompetent leader, exposing yourself to this type of investing will help you find the likes of Sam Walton at Wal-Mart (NYSE: WMT  ) or Reed Hastings at Netflix (Nasdaq: NFLX  ) , two visionary leaders whose daily passion and long-term mentality translated into life-changing wealth for their shareholders.

The long-term reward of finding just one 10- or 20-bagger will make an investing career and easily offset a few misses like DHB. And that's especially true when you widen your management evaluation toolkit to focus on additional attributes.

You see, my investing approach has never been about just one metric. At Motley Fool Million Dollar Portfolio, my hand-picked team evaluates a company's management based on a number of factors besides insider ownership, including tenure, capital allocation prowess, and stewardship.

  • Tenure simply measures how long an executive has been at his company. I love to see leaders who worked their way up the corporate ladder, accumulating decades of relevant experience. One prominent example is Procter & Gamble (NYSE: PG  ) CEO Bob McDonald, who started as a laundry brand assistant in 1980 and gradually took on positions of increasing responsibility throughout the company over the years.
  • Capital allocation refers to a management team's ability to invest in value-creating projects. This will show up over time as sustainably high return on equity (ROE) and return on invested capital (ROIC). I have been impressed by Chipotle Mexican Grill co-CEOs Steve Ells and Monty Moran, whose focus on streamlined operations and a promote-from-within culture have produced one of the most efficient restaurant chains around. In addition, both Chipotle execs demonstrate palpable passion for their business, another key predictor of success.
  • Merriam-Webster defines stewardship as "the careful and responsible management of something entrusted to one's care." That's pretty straightforward, but I'll boil it down even further to a golden rule of investing: You should want your managers to treat you just as they'd want to be treated were the roles reversed.

For example, Costco Wholesale (Nasdaq: COST  ) CEO Jim Sinegal has repeatedly resisted raising his salary, even though the company's compensation committee has suggested that he is underpaid. When Costco ran into some "improprieties" about options backdating, Sinegal and CFO Richard Galanti voluntarily forfeited their bonuses. That's the epitome of stewardship -- taking full responsibility and putting shareholders first.

Putting it all together
So, while I believe that individual investors would see a boost in their returns by focusing more on insider ownership, I believe they would enjoy a tremendous advantage over the rest of the market by widening their management evaluation scope to include these other often-overlooked attributes. That's especially true when that management analysis is combined with a thorough review of factors such as competitive advantage, financial strength, and valuation.

At Million Dollar Portfolio, my hand-picked team puts the best stocks from the Motley Fool universe through the proverbial wringer, selecting only the best of the best for our real-time, real-money portfolio. 

Tom Gardner is co-founder of The Motley Fool. He owns shares of Cisco Systems. The Motley Fool owns shares of Chipotle Mexican Grill, Costco, and Procter & Gamble. Dolby, Costco, and Netflix are Motley Fool Stock Advisor recommendations. Costco and Wal-Mart are Inside Value picks. Chipotle is a Hidden Gems and a Rule Breakers selection. Procter & Gamble is an Income Investor pick. The Fool has a disclosure policy.


Read/Post Comments (13) | Recommend This Article (121)

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  • Report this Comment On November 02, 2009, at 6:27 PM, Beebzer wrote:

    Interesting. As an experiment, I have been adding stocks to my Caps portfolio *strictly* on the basis of clusters of insiders buys--just to see how these "insider" stocks perform against the market average--although I'd never actually do that in my real portfolio. But the joke was on me: the Caps portfolio has vastly, vastly overperformed my real one!

  • Report this Comment On November 02, 2009, at 6:55 PM, henryking54 wrote:

    "The only metric I need"

    "my investing approach has never been about just one metric."

    Contradiction, anyone?

  • Report this Comment On November 02, 2009, at 7:06 PM, McCaution wrote:

    Tom

    Why would you recommend Assurant which has 1% inside ownership?

  • Report this Comment On November 02, 2009, at 8:47 PM, ds10 wrote:

    Insightful article. Approach worth a try.

    How do you access a company's 14A filing?

  • Report this Comment On November 02, 2009, at 8:52 PM, Pyrrhic wrote:

    I'd also like to know how to find a company's 14A filing, and how to find out when the "insider" dumps a large amount of stock to cash out.

  • Report this Comment On November 03, 2009, at 8:44 AM, wrldtrvlr wrote:

    A 14A is an SEC filing that public corporations are required to make.

    Simply check the filings for the companies that interest you and you're on your way.

  • Report this Comment On November 03, 2009, at 10:14 AM, TMFGebinr wrote:

    The 14A filing, the longer name is DEF 14A, is the annual proxy statement filed by the company with the SEC, prior to the annual meeting. A company's filings can be read from the SEC's website at http://sec.gov/edgar/searchedgar/companysearch.html. Enter the ticker, and then filter by filing type.

    For instance, to pick Costco from Tom's article, the proxy statements are found at http://sec.gov/cgi-bin/browse-edgar?action=getcompany&CI.... Then just click through the one you want to see and read it.

    Senior management's and directors' ownership stakes for Costco are on page 7 of the latest one at http://sec.gov/Archives/edgar/data/909832/000119312508255787...

    Sinegal beneficially owns about 2.3 million shares, which means he has about $133 million worth of stock, well above Tom's $10 million target.

    Cheers,

    Jim

  • Report this Comment On November 03, 2009, at 12:52 PM, Beebzer wrote:

    Insider buying can be found on sites like gurufocus.com

  • Report this Comment On November 06, 2009, at 11:53 AM, buynholdisdead wrote:

    Great article. This makes alot of sense. As far as DHB goes I would think that is why you would want to look more closely at the CEO. So there is one more metric I got from this article. If he or she has had a face lift on the company dime you might not want to invest.

  • Report this Comment On November 07, 2009, at 7:06 AM, straterrific wrote:

    Good article Tom. With regards to DHB, it might have been interesting to tell us what the other metrics were telling you at the time of your recommendation.

  • Report this Comment On November 07, 2009, at 11:09 PM, gedit wrote:

    Contradictions it is.

    When Tom stumbles on his own story then he says: "That is why we need more than one metric". No kidding. You need to know about the underlying Product my friend, and a lot of luck too.

  • Report this Comment On November 08, 2009, at 11:13 PM, debonator wrote:

    i'm really unclear where the stats on dolby's insider ownership are coming from. i've checked yahoo finance moneycentral, and both sites have dolby's inside ownership as under 1%. am i misreading something?

    here's a link for you, so you can see where i'm getting my info.

    http://finance.yahoo.com/q/mh?s=dlb

  • Report this Comment On November 09, 2009, at 7:09 PM, Counterparty wrote:

    http://finance.yahoo.com/news/W-Holding-Company-Inc-the-prne...

    WHI finally finished restating their 2008 numbers last week and the stock jumped from $ 11 to $ 15,70 in no time whatsoever. But with 3.3 million shares outstanding that still only gives them a market cap of 52 million compared to book value of 915 million.

    According to the latest filling the shareholder equity (assets minus liabilities) in the end only fell from 965 million at the end of 2007 to 915 million at the end of 2008, so that results in a current P/B of 0.06! Go figure!!

    It seems it's related to their 10>1 reverse split of last year, because the delayed fillings seemed to have caused the share price to go below the NASDAQ listing requirement at the time.

    The shares went from 33 million to 3,3 million, but the market doesn't seem to have noticed the 90% reduction in outstanding shares or something!

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