Master investor Marty Whitman -- founder of Third Avenue Funds -- told us two years ago that the greatest difficulty in stock investing is figuring out whether a company's executives give a damn about outside shareholders.
After all, the CEO at an average public company enjoys the following:
- A six- or seven-figure salary.
- The virtual guarantee of a 50% to 100% annual bonus.
- Substantial option grants at low strike prices (particularly if he sits as chairman of the board!).
Our quintessential CEO, then, runs his company for a mere four or five years, selling options all along the way. In this familiar model, his interests are only tenuously linked to those of outside shareowners. He's essentially just renting the executive suite, while long-term investors hold an ownership stake in the firm. In that scenario, it's not unusual for CEOs and other executives to get rich quickly while shareholders are decimated gradually.
We were recently reminded of Marty Whitman's point -- how tough it is to distinguish between promotional, self-obsessed managers and honorable, shareholder-friendly ones -- when thinking about the CEO (Leigh Abrams) and CFO (Fred Zinn) at Drew Industries (NYSE:DW), the market leader in the sale of components to manufactured homes and recreational vehicles. Last week, Drew announced a plan on the part of its executive leaders and board members to sell off holdings amounting to nearly 10% of the company. The market reacted as you'd expect, dunking the stock more than 9% before recovering.
The announcement came simultaneous to management reporting a pair of one-time benefits: a $1.5 million gain on the reversal of a legal matter and potential rewards from the rapid rise in Katrina-related orders for manufactured homes and RVs by the Federal Emergency Management Agency (FEMA). Put the three news stories together, and outside investors were right to wonder if management and the board were using temporary good news as a veil to their major stock sale.
We'd enjoyed the chance to sit down with Abrams and Zinn at their corporate headquarters in White Plains, N.Y. -- and we left very impressed. But going back to Whitman's point, we need to continually ask ourselves: "Are these enduringly great leaders or merely self-interested promoters?"
Within 24 hours, one of our writers, Rich Smith, carefully covered the story. Then, just hours after Rich's article was published, Tom received a phone call at Motley Fool Global HQ from Drew Industries CEO Leigh Abrams. Mr. Abrams wanted us to know that he'd be holding all of his core shares and only selling off a tranche of options (granted at fair value and expiring in November). It was a plan he'd openly disclosed to outside investors in the past year. "Furthermore," he added, "the core operators of the business are not major sellers. And we aren't going anywhere."
That might sound like nothing more than a great cover story while a management team cashes in on hype. But Abrams isn't a four-year CEO. He's been with Drew Industries since 1969, serving as its CEO for two decades. Since 1990, Drew Industries has risen more than 50 times in value. And the company has been intensely modest with its compensation, diluting outside shareholders less than 2% per year. Furthermore, Drew Industries has a CEO who takes the time to call influential shareholders when ambiguities arise. Why? Because he believes they are equal business partners in the firm. Look further down the list of Drew managers and you'd see the same thing: they haven't jumped from company to company. They're content, and they love what they do, which is why most of them have the majority of their wealth tied up in the company.
We submit to you that in Drew Industries, we've found a leadership team that feels a duty to outside owners. In the six months since Tom's formal recommendation of these shares in the pages of our Motley Fool Hidden Gems service, Drew has risen more than 35% (including a rapid rebound from the 9% dip this past week). And we happen to believe that such market-beating performance will continue over at least the next five to 10 years. (We only wish Tom had found this stock 15 years ago.)
This same high level of commitment to shareholders is, unfortunately, too rare. As we look across the management teams of all our Hidden Gems recommendations, we worry that not all will prove to be as forthcoming with, and as dedicated to, outside shareholders as is Leigh Abrams of Drew Industries. Current examples where we are not yet satisfied and have Martin Whitmanian questions include:
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CryptoLogic (NASDAQ:CRYP). Heavy stock option grants and bonuses at CryptoLogic come at a time when shares have cratered more than 50% because of poor strategic planning.
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FARO Technologies (NASDAQ:FARO). FARO insiders have expressed passionate enthusiasm for their business but have not bought a single share of stock, while gradually selling a mother lode of shares.
- Marine Products (NYSE:MPX). Each year, Marine Products pays millions in commissions to one of its directors in an enduring deal that we cannot believe favors outside shareholders.
There are very promising aspects to each of these businesses, which is why we continue to maintain our recommendation of them. However, in the past, we have made the decision to sell at least one company after a management team gave us wholly unsatisfactory answers to our questions. In other words, leadership counts a great deal to us. We identified another company as a promising investment but could not formally recommend it in Hidden Gems because of a long history of management behavior that we found, in a word, disgusting.
One of the 15 points that legendary investor Philip Fisher looks for in a great common stock is management with unquestionable integrity. When we spoke with management at TransAct Technologies (NASDAQ:TACT), we were extremely put off by their willingness to tout every market the company addressed as a "huge opportunity." Every company has opportunities, but we're not interested in being sold a story. There is always risk, and the management team should be able to clearly identify the risks. Management that is unable to give investors a clear-eyed view of where it is going and what challenges it must overcome to get there is of no interest to us. Contrast this with Leigh Abrams telling us that he had "no idea" whether any FEMA-related business would be a net positive to Drew (when even a wink to the market would likely send Drew's stock soaring), and you have in stark relief an illustration of what we value, and what we do not.
There are plenty of other reasons why Drew's stock has soared year in and year out for two decades, while TransAct has foundered. But we believe that shareholders are best served when the expectations that management sets for them are grounded in reality, not in what is vaguely possible if everything progresses without flaw.
Similarly, DHB Industries (AMEX:DHB), which we placed on the Hidden Gems watch list (and in Stocks 2004, replete with plenty of red flags) has managed to set extraordinarily low management behavior expectations and then failed to achieve them. This is a company where the founder owns a large slug of the company, but still sees fit to grant himself 1.5 million options at $1 per share, less than 25% of the current share price. Add in a host of related-party transactions and an insider trading scandal in the past, and we're frankly a little bit stunned that we allowed ourselves to get even this close to this company. We were just too intrigued by the superiority of DHB's product. Don't let that happen to you, because when smart management lacks integrity, you as an outside investor should assume that this intelligence is not being used for your ultimate benefit. They will brilliantly milk the company for their benefit -- and not give a damn about you.
With our existing recommendations listed above -- CryptoLogic, FARO Technologies, and Marine Products -- the jury remains out on whether their leadership groups care dearly about their long-standing and patient outside shareholders. We sincerely hope they do, as we are always prepared to be eternal owners of our favorite companies. Who knows? After reading this article, maybe they -- as Drew Industries CEO Leigh Abrams did -- will contact us to explain.
Fool co-founder Tom Gardner and Bill Mann fearlessly lead the Motley Fool Hidden Gems team. To date, Hidden Gems picks have returned 28% on average, compared with 9.5% for the S&P 500. Tom and Bill are offering a special 30-day free trial to Hidden Gems, which includes full access to the more than 50 small-cap stock recommendations to date. Click here for more information.
Tom Gardner and Bill Mann do not own shares of any company mentioned in this article. The Motley Fool has a disclosure policy.
