Education: Value Investing

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How to Consider Insider Ownership

If someone has a direct stake in the reputation and performance of a company, it would only make sense that they would do what is in their power to help the company succeed, right? Makes complete sense to me. What if I were to tell you that sometimes this can actually have the opposite effect? Caught me by surprise as well. Let’s dig a little deeper, shall we?

The Alignment Theory

When directors, officers or other key executives own shares of stock in the company they are currently employed by, this is referred to as insider ownership. A hypothesis referred to as the alignment theory suggests that the performance of the firm will be positively affected as the level of inside ownership grows. Thus, based on the theory, one can conclude that top performing companies will have very high levels of inside ownership.

For those interested in finding out what percentage of ownership can be attributed to insiders, we at Zacks provide that information for you. Go to www.zacks.com and type the ticker of the company you plan to research in the cell located in the upper left corner. When the Quotes and Research page pulls up, simply click on the Detailed Quotes link. Look for the figure corresponding to Insider Ownership.

Usually, the larger the company, the lower the number. This makes sense because with so many shares outstanding, it is very hard for insiders to hold a large percentage. Take General Electric Company for example. When putting this piece together, the company had only 0.2% insider ownership. Companies of smaller size typically have larger percentages.

The Entrenchment Theory

The validity of the alignment theory has been questioned by researchers, with evidence suggesting that the opposite may actually hold true. This hypothesis, referred to as the entrenchment theory, asserts that as key employees gain more and more ownership in the firm, the performance of the company actually suffers. Huh? This made me scratch my head as well; however, it starts to come together when you take the time to ponder over it.

Think of an employee that has been with a firm for quite some time. Over the years he has climbed the corporate ladder. He has proven to be quite a valuable asset to the firm, and in order to keep him on board, his ownership percentage has skyrocketed. More and more stock has been thrown his way. Eventually, this individual has achieved such a high level of power that complacency may set in. This entrenched manager can do as he pleases knowing that removing him from power will prove to be a very difficult task. And doing what he pleases may not always be in the best interest of the company for which he still works. Thus, the stock begins a slow, downward spiral.

Which Holds True?

So, is it the alignment theory or the entrenchment theory? It depends on the firm. Yeah I know that is the cheap way out. But seriously, the optimal level of insider ownership will vary by company. It is up to that company to find what this percentage should be. With most, it will lie somewhere between the two ends of the spectrum.

When analyzing various insider ownership percentages, don’t get alarmed if the number seems too high or too small. We as investors will have a very tough time deciphering whether or not a particular company has met its optimal level of insider ownership. What should catch one’s eye is when management is suddenly dumping a large number of shares. Or, on the contrary, when insiders are purchasing a fair amount of shares.

When management purchases shares of its own company’s stock, this is generally a sign that those individuals believe it is a good investment. The stock may perhaps be currently undervalued. They are displaying confidence in the future price appreciation of their company’s stock. On the other hand, if they are dumping their shares…

For those of you who would like to dig deeper into the insider ownership figure discussed earlier, there are two SEC filings that should be of interest to you. Form 4 reports changes in beneficial ownership of securities, while on Form 144 stockholders must report the intention to sell more than 500 shares, or $10,000 worth, of a company's stock in any three-month period. For more information click here to visit the SEC’s web site.