When Insiders Own, You Profit

If you don't know who Michael Mauboussin is, you should. He's a very sharp investor, and the chief investment strategist at Legg Mason Capital Management -- with a long list of accomplishments to his resume.

He's also one of the few investment luminaries who publicly share their thinking on stocks on the market. While there's any number of passages I could quote from Mauboussin, this passage from Mauboussin on Strategy on the importance of insider ownership strikes as one of the most lucid:

Relatively high insider ownership better aligns the economic interests of managers and shareholders. Managers with relatively significant equity will more likely invest only in value-creating opportunities than maximize firm size.

His words are spot-on. Companies where insiders own a chunk of stock tend to create value for shareholders over time -- because insiders are shareholders too. That's a far better goal than simply increasing revenue, earnings, or whatever metric management happens to have tied to its compensation package.

Not a perfect metric
Of course, most of the talked-about U.S. companies have low levels of insider ownership simply because they're so large. ExxonMobil, for instance, is not quite 0.1% owned by insiders, but that's not a red flag -- the company is just too large for insider ownership to mean anything.

That's not the case in small caps, though. Because these companies are small, the way they invest their limited resources can literally make or break them. In such cases, I want a CEO with a large portion of his or her personal wealth on the line.

The "two-six" case study
Let's look at II-VI (NASDAQ:IIVI) for an illustration. II-VI produces infrared optic and laser components, along with other high-tech products, for industrial and military applications. II-VI was founded more than 35 years ago, but co-founder Dr. Carl Johnson still owns more than 13% of the company and serves as chairman of the board.

II-VI is a small-cap success story. Revenue has grown at a compound annual rate of 18% for the past five years. The company generates gobs of free cash flow. It has a clean balance sheet and a conservative capital structure -- just $15 million in long-term debt, against nearly $40 million cash and investments.

II-VI went public in March 1990. Anyone who invested $10,000 on that day would be sitting on more than $400,000 today. But you didn't have to invest in this company 17 years ago to make a good deal of money. II-VI has doubled since Tom Gardner recommended it in Motley Fool Hidden Gems a year ago -- and if recent performance is a guide, this stock has room to run.

Why insiders matter
When most people discuss insider ownership, they approach it from the perspective of financially aligning the CEO's interests with those of shareholders. While there's some truth to that, it's not the most important point.

Founders who've stayed with their companies for many years, or even decades, obviously love what they're doing and have a passion for their business.

These people are incredibly important for establishing a company culture. The founder's passion is one of those X-factors that results in loyal and productive employees. This passion and determination can help a company dominate its competition.

The next great small cap
As a research analyst on the Hidden Gems team, I'm always looking for new ideas. I often screen for small-cap companies with high levels of insider ownership, trading near their 52-week lows. Six of the more interesting companies from a recent run of that screen are presented below:

These aren't recommendations, but they might merit further research. Of these companies, I'm most interested in IPG Photonics, a high-tech firm making major advances in the development of fiber lasers. IPG's revenue growth is eye-popping; its top line has nearly tripled over the past three years. Founder Dr. Valentin Gapontesev has retained a massive 46% stake in the business. Now that's an owner who believes in his company!

The Foolish bottom line
This is not to oversimply matters -- not every company with high insider ownership will be a fantastic company to own. There are other pieces to the puzzle, both tangible (strong balance sheets) and intangible (strong competitive advantages, durable brand). Remember that as you go searching for the next great small cap.

At Hidden Gems, we recommend two small companies each month. While we look at all the pieces to the puzzle, we absolutely love it when founders/managers own significant stakes in our companies -- as was the case with II-VI.

If you're interested in our approach, or would like to see our stock recommendation and research for free, you can sample our service with a 30-day guest pass.

Fool research analyst Charly Travers does not own shares of any company mentioned in this article. IPG Photonics is a Rule Breakers recommendation. The Motley Fool has a disclosure policy.