By Liam Pleven
Many chief executives hold major equity stakes in their
companies while turning them into powerhouses. Think of Jeff Bezos
of Amazon.com, FedEx's Fred Smith and Steve Wynn of Wynn Resorts,
to name a few high-profile examples.
Recent research points to a connection between high levels of
executive ownership and stock-market success. Companies led by
someone who owns at least 5% of the shares outstanding on average
generate higher returns for investors, according to a study
published last year in the Journal of Finance. When the executive
holds at least 10%, the level of outperformance is greater, the
authors found.
The report underscores the potential benefits of having the best
interests of top executives aligned with those of investors.
But that doesn't mean you should plow your money into stocks
with high CEO ownership levels. In fact, there are good reasons not
to.
Translating academic research into a practical investing
strategy can be risky. Many studies find potential links between
investment criteria and performance, but don't prove the former
drives the latter. What might have been effective in the past may
not work in the future. And you could expose yourself to hidden
risks.
Getting an Edge
The authors of the study, Ulf von Lilienfeld-Toal of the
University of Luxembourg and Stefan Ruenzi of the University of
Mannheim in Germany, looked at how hypothetical portfolios of U.S.
stocks with high levels of executive ownership performed from 1988
to 2010. The study focused on shares that the executive--usually
the CEO, and often the founding CEO--owned outright, largely
excluding options and similar types of long-term incentive
compensation.
A portfolio divided equally among companies in which an
executive owned at least 5% of the shares outperformed other firms
with a similar risk profile by an average of 5.7 percentage points
annually, according to the study.
A similar portfolio divided among companies in which an
executive owned at least 10% of the shares outperformed by an
average of 6.2 percentage points annually.
One likely reason, according to the authors: having the CEO own
a lot of shares can produce the same kind of beneficial effect as
strong corporate governance, which is generally intended to ensure
that managers focus on maximizing shareholder value.
"Giving managers freedom to follow their own course of action is
a good idea if incentives are in place that make sure they use this
freedom in the right way," the researchers wrote.
Mr. von Lilienfeld-Toal says constructing a similar portfolio
wouldn't be complicated. "You don't need to have a Ph.D. in finance
to do this," he said in an interview.
But it is worth keeping in mind some of the things that could go
wrong if you did.
Hunting for Gaps
First of all, professional investors constantly hunt for gaps
between current price and long-term value. If they believe that
firms with high CEO ownership are better bets, they may have taken
advantage of it by now and eliminated the opportunity for
others.
The researchers found no evidence that was happening in the
period studied. They suggested, in fact, that investors may avoid
bidding up share prices when the CEO owns lots of stock. Otherwise,
he or she could profit immediately by selling the stake without
having to put in the hard work of growing the company.
But that is just a theory. The bottom line is that just because
holding shares of these kinds of companies could have paid off
between 1988 and 2010 doesn't mean it will in 2015 and beyond.
In addition, a portfolio comprised of such companies also could
expose an investor to more risk than if they owned a fund that
invested in a broad market index, such as the Vanguard Total Stock
Market exchange-traded fund, which charges annual fees of 0.05%, or
$5 on a $10,000 investment.
Companies with a high level of CEO ownership "might be riskier"
than similar companies, says Randall Morck, a finance professor at
the University of Alberta who has studied companies where
executives own stock and praised the new study for adding to the
body of research on the subject.
For example, the share price of this kind of company could be
particularly vulnerable if the CEO were sidelined by illness or
death. Such a risk could be mitigated with a diverse portfolio,
because such problems would be unlikely to hit many companies at
once.
Companies where the CEO owns more than 10% of the shares "tend
to be smaller and younger than the average firm," the study found.
A blue-chip company that has been in business for more than 50
years is less likely to be run by a founder who owns 11% of the
stock.
More worrisome are risk factors you may not know about. If you
are getting higher returns, it is safer to assume you are taking on
greater risk in exchange.
Practical hurdles also are worth noting. The hypothetical
portfolios the researchers constructed typically comprised more
than 1,000 stocks.
The Price of Admission
An ordinary investor would likely either need to pay for data or
do the research, which would be time-consuming. Then the investor
would need to pay brokerage fees to purchase each stock, which
could quickly eat into any added returns. The researchers also
found evidence of outperformance in portfolios focused on firms in
which the CEO owned more than 10% of the shares, even if they
weren't rebalanced annually, which could limit trading costs.
Narrowing the field could also limit the costs of trading. There
are only 108 companies in the broad-market S&P 1500 in which
the CEO owns at least 5% of the shares, according to data from
S&P Capital IQ. In the S&P 500, which focuses on larger
companies, there are only 22, including Amazon.com, FedEx and Wynn
Resorts.
But investors who focus on a small pool of large firms could
lose the benefits of diversification. Companies with high CEO
ownership aren't immune from trouble--just consider Bear Stearns,
whose longtime chief executive, James Cayne, owned more than 5% of
the shares, according to a regulatory filing in 2007, the year
before the firm was sold on the brink of collapse.
Investors should think of executive ownership as one of many
factors worth considering before investing in a stock. And they
should remember that any individual stock is risky, regardless of
how much the CEO has at stake.
Email: liam.pleven@wsj.com
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