If you've been an investor for a while, you know that many events cause a stock to drop: Bad earnings, analyst downgrades, interest rate rumors, short sellers -- the list goes on. But here's an event you may not have pegged as a cause for your stock's recent slide: Your CEO just bought a palatial new estate.
Alas, according to recent research by professors Crocker Liu and David Yermack: "Future company performance deteriorates when CEOs acquire extremely large or costly mansions and estates." Why? Because it signals entrenchment -- a fat cat ready to rest on his or her laurels.
Nothing wrong with that, but
Richly rewarded CEOs have come under fire of late. Far be it from me to begrudge someone an opportunity to live large. Rather, the reason I find the Liu/Yermack study so interesting is that identifying engaged leadership is one of the best ways for individual investors to buy into the best-performing stocks of the next decade or more.
Many of the best-performing large stocks of the past five years, including Research In Motion
The leaders of these companies will someday move on, and when that happens, the entrepreneurial spirit that spurred these mammoth gains could be gone as well.
When zealots move on
Consider the cases of Dell and Microsoft. Founders Michael Dell and Bill Gates built each of these companies into global giants. As they saw their visions to fruition, early shareholders earned up to 200 times their money along the way.
But since Gates stepped down as CEO in 2000 and Dell in 2004, the stocks have stagnated.
Dell recently stepped back into the CEO role of his company, and Gates announced that he will be stepping down entirely from a full-time role at Microsoft to focus on his work at the Bill & Melinda Gates Foundation. This, of course, is wonderful news for Gates, his wife, the foundation, and the people the foundation will help -- but it's not so wonderful for Microsoft shareholders.
Compare that situation with that of another stock that's been stagnant recently: Berkshire Hathaway. As the Liu/Yermack study notes, Warren Buffett still lives in the Omaha house he bought in 1958 for $31,500. Moreover, when it came time for Buffett to give some of his fortune away, he announced that he would donate it to the Gates Foundation rather than set up his own foundation. This illustrates a founder/CEO who is still focused on his business work.
The Foolish takeaway
Engaged and entrepreneurial CEOs are among the best friends an individual investor could have in the marketplace. Of course, home purchases or new endeavors aren't the only indicators of a CEO who is no longer fully focused -- and that's why you need to keep tabs on the leadership of your companies as closely as you do the financials.
At our Motley Fool Hidden Gems small-cap investing service, we know that the leadership effect is amplified when it comes to small companies. And when you combine great leadership with a wide market opportunity, you have the opportunity for huge returns.
These are precisely the situations we seek at Hidden Gems, and the strategy has helped us beat the market by 19 percentage points since 2003. If you'd like to see the stocks we're recommending today, click here to join Hidden Gems free for 30 days. There is no obligation to subscribe.
This article was first published on April 17, 2007. It has been updated.
Tim Hanson owns shares of Berkshire Hathaway. The Motley Fool also owns shares of Berkshire. Dell, Microsoft, and Berkshire Hathaway are Motley Fool Inside Value recommendations. Garmin, Dell, and Berkshire Hathaway are Stock Advisor picks. The Fool's disclosure policy is the one who wants to be with you. Deep inside, it hopes you feel it, too.
