In the closing paragraphs of his book The Intelligent Investor, the late investment thinker Benjamin Graham leaves the reader to ponder a simple parting line of advice: "Investment is most intelligent when it is most businesslike." (Emphasis his.) This has been a lasting idea that continues to guide investors today, even though the first edition of Graham's book was printed more than 50 years ago.
From one point of view, it may be said that Graham was instructing readers to treat their investments with a business-minded approach, i.e., view stocks as shares in real-life businesses and not just pieces of paper to be traded round and round. While a legitimate interpretation, Graham's quote can also be read from another, more philosophical bent -- that the most pure investment action approaches the action of business itself, with business being the highest form investment. (Sharp-eyed Russian history buffs will note that this interpretation is similar in structure to the title of a book by Lenin, Imperialism, the Highest Stage of Capitalism. But don't confuse the two. Over the years, Graham's views have held up quite a bit better than Lenin's -- and have proven to be much more lucrative to boot.)
If you buy into this philosophical interpretation of Graham's quote, then who better to ask about an investment in a company than the people who actually run the company? After all, isn't a firm's CEO the practitioner of the "highest stage of investment"? From this idea sprouts the investing concept of tracking insider holdings, which has been incorporated into the Foolish 8 small-company investing system with the requirement that at least 10% of a firm's stock be held by a company's executives, or "insiders."
Like the screens for maximum annual sales and daily dollar volume, the 10% insider holdings bar is more of an orientation screen than an illumination screen. In other words, the requirement orients the small-company investor toward the right general issue rather than illuminating some fundamental truth about the business. The concept of insider holdings is the important part of the requirement, not necessarily the 10% threshold. In the same way, the annual sales screen orients an investor's attention on revenues instead of market cap, and the daily dollar volume limit encourages sound qualitative analysis and a long-term investment view.
An insider holdings requirement helps the Foolish 8 investor focus on the important question of whether the interests of the "insider" shareholders coincide with those of the "outsider" shareholders. Attractive small businesses are run for the benefit of all shareholders, not just the folks at the top of the managerial totem pole. But how can you tell the former from the latter?
Unfortunately, there is no magic insider holdings percentage figure that makes one company more desirable to an outside investor than another. Some investors like to see very high levels of insider holdings at their companies, say above a 50% stake. Outside of personal anecdotes, I've come across little information documenting the benefits of investing in companies with a certain percentage of insider holdings versus another (if I've missed some study or finding, please feel free to email me). Requiring a 10% insider stake from your companies seems reasonable, although a quick screening indicates that the large majority of publicly traded firms jump over this hurdle without any problem.
For small companies, there may be a case to be made in favor of a large percentage of insider holdings, although this is more of a hunch than a conclusion and cannot be backed up with hard data. As has been pointed out before, large institutions are less likely to hold stakes in small companies than larger companies. Theoretically at least, this would leave a higher percentage of shares available to be held by the small company's insiders. Further, many small companies are little more than publicly traded family businesses, so it shouldn't be surprising to see instances where a large chunk of a family's net worth is tied up in a single company's stock.
The bottom line is that insider holdings are an important consideration for small-company investors, but the appropriate percentage level of insider holdings depends greatly upon the individual company's circumstances. A large amount of holdings may suggest that a firm's management eats its own cooking, or it may suggest that top management is intent on running the company like some sort of corporate fiefdom. It all depends on the individual company and its managers.
Like all other single-shot data points, the exact level of insider holdings doesn't tell an investor all that much by itself. But that doesn't mean it isn't an important consideration for investors. When the holdings figure is combined with operational data about the business and discussions with the insiders themselves, a better picture about the abilities of a company's management team and their view toward other shareholders will begin to emerge.
Some observers have made tracking changes in insider holdings into some kind of stock speculation sport, but such gamesmanship gets away from the spirit of Graham's businesslike approach to investing. If the people running the show are the highest-stage investors Graham posits them to be, then their performance will be measurable in other ways besides insider holdings. But examining the level of insider holdings and asking managers about the stakes they own are not bad starting points when it comes to trying to size up the value of a management team.
[Motley Fool Research's Industry Focus 2001 features more on Foolish 8 small-cap stocks.]
