This Is When You Sell

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If you've been an investor for any length of time, you know that many events can cause a stock to drop: bad earnings, analyst downgrades, interest rate rumors, short-sellers -- the list goes on and 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 laurels.

Not that there's anything wrong with that
While richly rewarded CEOs have come under fire of late, far be it from me to begrudge someone the 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.

Indeed, many great-performing businesses of the past five years, including American Oriental Bioengineering (NYSE: AOB), Willamette Valley Vineyards (Nasdaq: WVVI), VASCO Data Security (Nasdaq: VDSI), ArcelorMittal (NYSE: MT), and True Religion Apparel (Nasdaq: TRLG), are run by dedicated founders/CEOs who own a slug of shares and have something to prove. This is not to say that founders are infallible, but it generally is a positive long-term element to superior performance and a good indicator that a company can survive tough times such as today.

That said, I fully expect the leaders of each of these companies to someday move on, and when that happens, the entrepreneurial spirit that has spurred these mammoth gains will be gone as well.

What happens when zealots move on
For evidence of the consequences here, consider the cases of Dell and Microsoft. Michael Dell and Bill Gates, respectively, founded these companies and built them into global giants. As they saw their visions to fruition, early shareholders earned up to 200 times their money along the way.

But look at what's happened since Gates stepped down as CEO in 2000 and Dell in 2004. The stocks have stagnated.

While Dell recently stepped back into the CEO role for his company, 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 not so much for Microsoft shareholders.

Contrast that situation with that of another stock that's been moving up recently: Berkshire Hathaway. As the Liu/Yermack study notes, Warren Buffett continues to live in the Omaha house he purchased 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, in other words, describes a founder/CEO who is still focused on his work.

The Foolish bottom line
Engaged and entrepreneurial CEOs are among the best friends that the individual investor has 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 believe that the leadership effect is even more 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 out at Hidden Gems, and the strategy has helped us beat the market 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 April 17, 2007. It has been updated.

Tim Hanson owns shares of AOB and Berkshire Hathaway. AOB is a Motley Fool Hidden Gems recommendation. Dell, Microsoft, and Berkshire Hathaway are Motley Fool Inside Value recommendations. Berkshire Hathaway is also a Stock Advisor pick, as is VASCO Data Security. The Motley Fool owns shares of Berkshire Hathaway and AOB. The Fool's disclosure policy is the one who wants to be with you. Deep inside, it hopes you feel it, too.