Insider Ownership: The Perfect Stock Signal?

| About: SPDR S&P (SPY)

Summary

Shareholders have a tendency to monitor this easily followed metric.

Buying when insiders buy and selling when they sell seems to make sense at first hand.

Like anything else in the markets, it can actually be a warning sign that something is amiss.

Insider ownership is often heralded as a surefire way of improving the relationship between company management and the shareholder. Entire investment strategies have been developed that simply revolve around following insider transactions; buying when they buy and selling when they sell. But like anything in investing, there are two sides to this coin, and its worth keeping an open mind when it comes to any investment strategy to look for faults. In this case, investors need to think about the incentive structure that is put into place when insiders become deeply invested in the very same companies they manage.

Investment Banking Compensation Parallel?

For me, the quickest and easiest example that I can make that will likely resonate with investors is to draw a comparison to the compensation structure within investment banking just a few short years ago. As we entered the recession, driven in part by overzealous risk-taking by some of our largest financial institutions, many saw a fatal flaw in how investment bankers were paid. Linking a large percentage of pay to highly variable bonus compensation, both in cash and in stock, was incredibly common. Short vesting periods were the norm and clawbacks were unheard of. As a result, revenue-generating employees were heavily incentivized to engage in high risk, high reward trades, often with short-term payoffs. Doing so helped ensure a hefty bonus check come year-end reviews, and we all know in hindsight this high risk appetite compounded losses when liquidity for risky assets simply dried up in 2008.

Far from learning a lesson from banks' woes, companies are increasingly moving executive compensation to stock grants and options rather than keeping traditional cash payouts in place. This is the direct opposite of investment banking pay, which is moving towards high base salaries and less bonus payouts, with the bonuses that remain having extremely long vesting periods with extensive claw back provisions.

While there are numerous reasons for members of the executive suite to become overly aggressive in business management (or to resort in downright fraud), in my opinion there is no bigger motivator in this world then trying to put more money in one's pocket. That isn't a bad thing; self-interest is incredibly rational behavior. However, senior management is in the rather unique position of being able to perpetrate aggressive accounting practices or to engage in fraud because those individuals are in a perfect position to either manipulate accounting records themselves or direct employees to perpetrate actions on their behalf.

There are numerous historical examples to cite. In fact, if you look back at some of the most well-known fraud cases in history, you can generally find that management had large amounts of personal wealth tied up the company. The CEO of Enron, Jeffrey Skilling, sold nearly $60M in stock before abruptly leaving the company just before it collapsed. Not every sneaky, and he is still waking up each morning in a jail cell in Alabama. Joe Nacchio of Qwest International sold $52M of stock on inside information the company was going deeply underwater, driven in part by his own aggressive risk-taking strategy. Bernie Ebbers of WorldCom, in order to prop up the value of company stock because he had used as collateral for large personal loans, misstated more than $9B in accounting entries.

Accounting Warning Signs

Overall, I still tend to react favorably overall to insider ownership, but I'm always cautious in both looking at the size and structure of the executive compensation package and looking for signs of accounting fraud. As for the methods, there are a few that are most often used. Aggressive revenue recognition is the most prevalent, done primarily by recognizing revenue before it is supposed to be via GAAP. This can be done via bill-and-hold sales agreements, shady operating lease agreements, and recording revenue before true delivery/contract fulfillment.

General expense misstatement is another big method, primarily within areas in GAAP accounting that give management leeway in how they report. Under-reporting depreciation and amortization is a tempting method. Overstating an asset's useful life yields quick benefits, and in the case of longer-lived assets, can push discovery well off into the future. Careful examination of close peers can yield signs of depreciating assets in methods not followed by the industry as a whole.

Overall, this is a prime reason why I focus more on the statement of cash flows rather than the income statement. While there are means of manipulating cash flows, its usually more readily apparent. In fact, the statement of cash flows can often yield signs of income statement shenanigans. Flat or declining operating cash flow while earnings rise is often a surefire means of spotting aggressive accounting.

Conclusion

Overall, insider ownership can be a healthy sign. Linking executive pay to shareholder interests aligns both parties in benefiting from a higher stock price. But it is important to remember that a rising stock price does not necessarily mean that management is making healthy decisions to benefit the company in the long term. But, there are no shortcuts to beating the S&P 500 (NYSEARCA:SPY), or whatever your benchmark might be. High insider ownership does not mean that investors should fall asleep at the wheel at their job of monitoring company direction. In short, there are no shortcuts around doing your proper due diligence.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.