Know When Insider Ownership Really Matters


Paying executives in stock and options has long been seen as a way to align the interests of executives and shareholders. But that doesn't work if the executives turn around and sell those shares. So increasingly, boards of directors are requiring executives to retain a minimum number of shares. Problem solved? Unfortunately, not really.

Share-based pay has had a meteoric rise over recent decades. In the 1980s, CEO compensation was roughly 26% in stock and options. After 2000, the proportion had risen to above 60%. This could be seen as a shareholder-friendly shift -- if executives have more skin in the game, the argument goes, they'll make decisions that will benefit all shareholders.

But consider the case of Bear Stearns and Lehman Brothers. In their paper "The Wages of Failure," Harvard's Lucian Bebchuk, Alma Cohen, and Holger Spamann point out that though the commonly held view suggests that "the wealth of the two companies' top executives was largely wiped out with their firms," the truth is quite different. The research team found that between 2000 and 2008, the executives at Bear and Lehman were able to pocket a total of $2.4 billion in cash bonuses and stock sales. That total "substantially exceeded" the amount of stock that the group owned at the beginning of the period, so, as the title of the paper implies, despite being paid a significant amount in equity, these executives cashed in as shareholders were wiped out.

The trouble with forced ownership
The logical next step may be to require executives to hold a certain amount of the shares they're given. University of Bristol researchers Piotr Korczak and Xicheng Liu found that this has been an increasingly common response from boards. Back in 2000, 12 of the FTSE 350 companies had minimum ownership guidelines for executives. By 2009 that number had risen to 172.

Korczak and Liu's research, however, found that a significant unintended consequence of this type of policy may be that once given an ownership minimum, executives tend to use that minimum as a ceiling for their holdings. As the researchers put it: "While being below the minimum does not significantly reduce rebalancing, executives significantly enhance rebalancing and retain fewer shares when they are above the minimum... The policies may not only fail to limit the unwinding of equity incentives, but also further reduce share retention."

But that's not even the point
On the Motley Fool Money radio show a couple of weeks back, Motley Fool co-founder Tom Gardner touched on executive ownership and its significance for investors.

As an investor, I love to find the founder/CEO who's put their entire life into their organization... What I love are the stories where Jeff Bezos could have stepped down from Amazon [ (NAS: AMZN) ] a long time ago, I mean he has more money than anyone would ever need... Same thing is true of John Mackey [of Whole Foods], same thing with Howard Schulz at Starbucks [ (NAS: SBUX) ], same thing with Warren Buffett at Berkshire Hathaway [ (NYS: BRK.B) ].

Notably, Tom wasn't talking about companies whose executives had hoovered up shares because their board made them. He was talking about companies whose executives have big ownership positions and think like owners precisely because they are owners. These are companies that those executives built, and they have a vested interest -- monetarily and otherwise -- to see their companies succeed over the long term.

You just can't force that sort of attitude through board mandates.

Putting it to work
What's the best way for investors to use this to their advantage? One obvious way to handle this issue is to stick to companies where founders with a large ownership stake are in leadership roles. As Tom put it on Motley Fool Money: "That's a really good, simple screen: looking for companies where the founder is still the CEO."

In addition to the companies that Tom mentioned, Google, Oracle (NAS: ORCL) , and, yes, Facebook (NAS: FB) are also examples of companies where the founder is still the CEO and owns a sizable chunk of the business.

While some investors may welcome the drastic paring down of the investment universe that comes from focusing exclusively on companies that have large-owner/founders at the top (there aren't that many), this doesn't mean that investors have to pass over every other company out there. There are, after all, very talented non-founder executives -- I tend to prefer those who have been with the company they're leading for a long time -- who can be well worth backing even though they don't own a significant stake in the company they're running.

Investors who do look outside of owner/founder-led companies will want to seek out good governance in general, though. That is, a company that's being run for the benefit of all stakeholders, not just hired guns at the top. A company's proxy statement -- which is filed annually with the SEC -- is a great place to find that out. While there are many hallmarks of good governance, here are a few to get you started:

  • Non-executive board members. In their research, U of Bristol's Korczak and Liu found that executives tended to hold on to more shares when the board included a higher percentage of non-executives. More generally, a board with fewer executives is also less likely to end up a clubby group that simply caters to insiders above other stakeholders.

  • Pay for long-term performance. In the proxy statement, the board outlines how executive compensation is structured. Investors should consider whether the incentives set up for the company's leadership are truly long-term oriented or if they reward potentially detrimental short-term thinking.

  • The boards' stake. Shareholders want the board to look out for their interests and advocate for them as the company's owners. If there are board members who own significant amounts of stock, outside investors may be able to rest easier believing that the board is going to do just that. The proxy statement discloses the ownership of board members as well as executives.

The bottom line is that a founder/owner attitude, or even a dedication to good stewardship, is not one that can be forced on an executive by the board through share-ownership mandates.

The big Zuck
Not only is Facebook a company whose founder is still the CEO and top shareholder, but it's also one of the most controversial stocks in the market right now. Should you take a chance and back the hoodie-wearing Mark Zuckerberg? Or is it best to steer clear? Motley Fool tech whiz Evan Niu has dug into the details of the company and the stock to put investors on the fast track when it comes to Facebook. Click here to check out his premium report: "Should You Be Friends With Facebook?"

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