An investment strategy centered on insiders’ share positions makes sense in principle and it’s an important factor for investors in the emerging growth universe.
Of course, any trading by a company’s officers, directors or anyone else with access to key corporate information before it’s publicly available can be a sign of things to come. However, when analyzing insider trades it is best not to interpret them as a strong reflection of the company’s outlook unless they are done in the extreme or a pattern emerges among insiders.
If this strategy by itself was so simple investors would only need to monitor insider activity through SEC filings and press the button. Indeed, while some do that, most prefer to add layers of depth to insider trading strategies to support their decisions.
In the stock market, single-factor strategies are typically doomed to fail unless you have big data spanning over a long time to back it up. For small and microcap companies, multi-factor investment strategies are essential – especially for long-term investors.
Insider ownership levels show the amount of shares and percentage of the outstanding shares held by corporate leadership. That’s a good starting point.
It’s also valuable to learn about how much of their own money that corporate leadership has invested, if any, and the rundown on their stock options, including timeframes, amounts and pricing. Incentives should be aligned with the company’s peers; if they’re not, an investor needs to understand why.
It is common for a CEO or another corporate officer to exercise stock options to buy stocks at a discount or receive stock compensation; however, it is fairly uncommon for management to invest personal money in their company. This signals confidence or good faith and implies that the company is progressing and the share price will rise in the future if the business executes.
Founder led companies are usually a positive because this is what Wall Street likes to call ‘skin in the game’. In this case, the leadership is not just a hired executive who may or may not be fully committed. Berkshire Hathaway’s Warren Buffett and Amazon’s Jeff Bezos are among the best founder success stories.
Does Insider Ownership Correlate with Performance, Valuation?
Intuitively it seems that higher levels of insider stakes are aligned with the interests of shareholders and that companies with managers holding big positions should outperform those with smaller ones.
It turns out that there is a dearth of data on insider ownership and its correlation to stock performance. In our search, we soon realized that most of the writings on the topic were published before 2012. This was in the aftermath of the Great Financial Crisis when investors were mired in the recovery phase.
An in-depth study titled “Why are Firms with More Managerial Ownership Worth Less?” was published in Dec. 2018. The 59-page report was authored by Kornelia Fabisik of Frankfurt School of Finance & Management, Rüdiger Fahlenbrach of Ecole Polytechnique Fédérale de Lausanne; René Stulz of Ohio State University, and Jérôme Taillard of Babson College.
“With our [large] sample, we find strong and robust evidence that the relation between firm value and managerial ownership is negative rather than positive and thus opposite to theoretical predictions and prior empirical findings. Yet, when we restrict our sample to the subset of larger firms similar to the samples used by earlier work, we recover their findings of a positive relationship between value and managerial ownership over some range of ownership…
“We find strong evidence that a firm’s current managerial ownership is a decreasing function of the number of years the firm has had with high stock liquidity, which are years in which managers could have decreased their ownership at lower cost…
“Our explanation for the negative relation between managerial ownership and Tobin’s q [which equals the market value of a company divided by its assets’ replacement cost] is that higher liquidity decreases managerial ownership and that some of the forces that lead to higher liquidity increase Tobin’s q as well. In particular, better operating performance generally improves both liquidity and Tobin’s q. We find strong support for the hypothesis that a stock is more liquid if its cumulative past performance is better. We then show that Tobin’s q is also higher for firms with greater past performance.”
In other words, when smaller firms are included in the larger sample, a higher ownership of shares by management is negatively correlated with companies’ valuation. This research indicates that as companies mature and operating performance improves, so does liquidity and the opportunities for management to cash out.
Back in 1999, hedge fund manager Whitney Tilson wrote an article for a general investor audience that queried stocks in the S&P 500. He tested different timeframes in a less-than-rigorous study and reported the following:
“While the differences in returns aren't that great among most of the cohorts (for example, the 10-year return for stocks with 20-29% insider ownership is only 3% more than stocks with 2-4% insider ownership), in every time period there is a huge jump in returns when insider ownership is 30% or more. This could imply three things:
-Insider ownership may only really matter when it's very high, or
-The key variable is not the degree of insider ownership, but rather whether a company's founders still hold large stakes (since insider ownership of 30% or more generally only happens when the founders hold on to their equity), or
-With only 15 data points, which include a few phenomenal performers such as Dell, Microsoft, and Charles Schwab, the sample size could be too small for the results to mean anything.
Tilson concluded that while his analysis is far from definitive, he believes that insider ownership is a plus. He also said that modest differences do not influence his decision whether to buy one stock versus another.
We’re in agreement on both points. More than two decades later, experience and anecdotal evidence suggest that these views still hold up today.
Sizing Up Emerging-Growth Company Insider Ownership
Naturally, we were curious to see how insider ownership is distributed for all stocks below the $2 billion threshold. Applying a screen we created three cohorts: Nanocaps (up to $50M), Microcaps ($50M-$300M), and Smallcaps ($300M-$2B). Here’s how it looks:
Insider Ownership
<5% <10% <20% <30% <50%
Nanocaps 36% 48% 60% 72% 83%
(n=354)
Microcaps 46% 58% 70% 76% 81%
(n=1,370)
Smallcaps 57% 65% 73% 76% 80%
(n=1,998)
We find notable decreases in insider ownership as market cap rises, just as the researchers in their Dec. 2018 paper discussed. Here too, better operating performance and liquidity are almost certainly key factors for the differences across the groups.
Most interesting is that more than one-half (53%) of small and microcaps have less than 10% insider ownership. Ten percent is a reasonable level. Yet applying it as a minimum eliminates nearly 1,800 companies with market caps from $50 million to $2 billion.
Unquestionably insider ownership is an important element in emerging-growth company investing. While a multitude of factors must be integrated into research and decision-making, a company with insider holdings below 10% requires deeper investigation into management incentives and history of capital structure to alleviate any doubts about lack of skin in the game.
See you next week, and thank you for your support.
Josh
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