If you've been an investor for any length of time, you know 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 its 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.
Just take a look at the short list of 25 large caps that continue to be more than 20% insider-owned. It's a who's-who of market success stories, including Nike
An entrepreneurial spirit spurred the mammoth gains these stocks achieved. Of course, what the Liu/Yermack study shows is that when that spirit dissipates, the stock slows.
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 each of 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 of 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.
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 on 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 by 35 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 does not own shares of any company mentioned. Dell and Microsoft are Motley Fool Inside Value recommendations. Dell and eBay 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.