Research Shows That CEO Ownership Matters

 |  Includes: FB, MSFT, ORCL, TSLA, YELP
by: Jacob Steinberg

CEOs are the most valuable employees of a company. Often times, CEOs will be the ones who save or end a company's life with their day-to-day decisions. Other times, a CEO's existence alone will calm the markets and gain trust of the investors, which is very important in a market driven by emotions such as greed and fear. Academics have studied the effects of CEO behavior on stock performance for many years and found some remarkable results. One such study was conducted recently by Ulf Von Lilienfeld-Toal and Stefan Ruenzi to determine whether CEO ownership of a company can predict stock performance in the long run. I will describe this study and its implications in this article.

In almost every public company in the world, CEOs own some shares and they care about shareholder value since they are one of the shareholders. On the other hand, some companies enjoy a higher CEO ownership than others. The researchers mentioned above define high CEO ownership as a situation where a CEO owns more than 10% of the outstanding shares of a company that he or she runs. One such example is Tesla (NASDAQ:TSLA), where Elon Musk owns about 28 million shares out of the 122 million outstanding shares of the company (percentage-wise, this would correspond to 22.95%).

When a CEO owns a big chunk of a company, this can lead the investors to think a few things. First, investors are convinced that the CEO believes in the future of the company since he or she is heavily invested in it. Second, investors feel that the CEO will do his or her best in order to maximize the value for shareholders since he or she is a major shareholder. Third, investors believe that the CEO has vested interest in the company's success and cannot just leave the company and go somewhere else (at least not easily so). Fourth, a company with high CEO ownership might be actually founded by the CEO, and this could indicate to the investors that the CEO knows how to initiate and run a business in a given industry. Fifth, many times CEOs will implicitly tell investors to buy shares of their company by doing it themselves ("look, I am putting so much money in the company I run and I am putting my money where my mouth is, perhaps you should follow my lead").

The researchers mentioned above created portfolios where CEOs own 10% or more of the company they run, and this portfolio reportedly outperformed the market by 5% annually between 1988 and 2010. This indicates a higher performance than 95% of the mutual funds in the US that are actively managed by experienced fund managers. Some might think that this could be because companies that have higher CEO ownership tend to be smaller than the companies that have low CEO ownership; however, the researchers found out that the strong relationship was persistent even after using statistical tools to control for the company size.

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After doing additional statistical testing, the researchers pinpointed the reason why companies with high CEO ownership outperformed the overall market. It turns out that this has very little to do with a CEO's belief that a company is undervalued; rather, it is more related to the idea that a CEO will actively seek to maximize shareholder value by doing whatever it takes to bring success to the company. In fact, in companies where CEOs enjoyed higher levels of discretion, the relationship between CEO ownership and stock performance was even stronger and annual abnormal gains were closer to 10%. Interestingly enough, asymmetric information (the situation where CEOs know a lot more about a company than investors and analysts do, so they can make an investment decision on the company's stock based on this insider information no one else seems to have) was also examined in this study, but it did not explain the results in any way.

All evidence shows that when a CEO's goals are aligned with the goals of the shareholders (in other words, when they have the same goals as a result of CEO being one of the shareholders), the stock price outperforms the market by a nice margin. Would Tesla rally so much if Elon Musk was not a large shareholder of the company? Probably not. Tesla is not the only example either. Facebook's (NASDAQ:FB) Mark Zuckerberg is another good example. Mr. Zuckerberg holds about a third of Facebook's outstanding shares, and he has made tremendous effort in the last couple years to increase shareholder value. As a result, most of the people who bought Facebook's shares anytime in the last year are celebrating a big win at the moment.

As I mentioned above, discretion power of a CEO makes a big difference in the relationship between CEO ownership and a company's stock performance. After all, if CEO of a company does not hold much decision-making power in a company, his or her ownership may not make all that much difference. In both examples of Tesla and Facebook, CEOs seem to enjoy a lot of discretion power. When Bill Gates was the CEO of Microsoft (NASDAQ:MSFT), he owned a large chunk of the company and he enjoyed a lot of decision-making power, and this situation ended up benefiting many investors for years. The study mentioned above found that a company's stock returns are maximized when the CEO holds a lot of shares and enjoys a lot of decision-making power in the company. This way, the CEO can align his or her goals with the shareholders' goals and take the right steps to ensure those goals are met. The study found results confirming this: when the CEO ownership and CEO discretion are high, the companies have higher return on assets and higher margins overall because costs are being kept low and "empire building" behavior is seen less in those companies. You can see this in companies like Facebook, where operating margins are above 50% and the company is accomplishing a lot with relatively few employees.

Of course, there are always exceptions to the rule. For example, Yelp's (NYSE:YELP) CEO Jeremy Stoppelman sells every share he receives on the day he receives them. Financially speaking, the company is not showing much of a success as it has yet to see profitability, yet the market continues to reward the company with very strong returns, as the stock more than doubled in the last year. Oracle's (NASDAQ:ORCL) CEO Lawrence Ellison owns more than 1 billion of the company's 4.5 billion outstanding shares, but the company's stock market performance has not been that impressive in the recent years. In the last 3 years, Oracle's share price has appreciated by about 12%, whereas S&P rallied by about 37% during the same period.

Do the results of this study mean that investors should just go ahead and buy companies where CEOs own more than 10% of the outstanding shares? According to the study, such a portfolio would outperform the market consistently; however, we can usually find any patterns in the data if we look at the past and that doesn't mean these patterns will carry on to the future. During the dotcom bubble, there were many algorithms that claimed to be able to predict a stock's performance and many of these algorithms saw some success in the short term as the market was going up constantly; however, most of those algorithms failed miserably once the market crashed. At least the idea of these researchers makes sense and there is good logic behind it.

Disclosure: I am long FB, MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.