The hidden power of CEO stock ownership

Management ownership of stock turns out to be extra important when it comes to the best performing small caps.

Summary: The alignment of director interests with shareholders is particularly important for small caps due to the higher level of uncertainty with undiscovered companies. There is a strong correlation between chief executive ownership and long term returns to investors. 

Key take-out:  Eureka's share recommendations have a high level of chief executive ownership, making them well placed to outperform in the long term.

Key beneficiaries: General investors. Category: Shares.

One of the key criteria to identifying great companies is a quality management team with interests aligned to shareholders. Over the long term we have found a strong correlation between total shareholder returns and a high level of chief executive share ownership... but what about small cap stocks – are they any different? 

To investigate the strength of the relationship we first analysed the best and worst performers for the S&P/ASX300 index. We also had some assistance from Guerdon Associates – The Australian based experts in equity and executive pay.

Michael Robinson from Guerdon has the view “it is important to consider the board’s governance towards chief executive ownership in general, rather than just the current chief executive’s position.”

For example, the Westpac board has a requirement for the market value of chief executive Gail Kelly’s Westpac shares to be five times that of her annual base salary.

We then compared the level of chief executive ownership of the best and worst performers with that of the 13 stocks I have active calls for in the Eureka Share recommendations page.

And guess what? We found that when it comes to small caps the top management at our favourite companies are considerably more committed financially than their blue chip counterparts. Putting it into numbers, the top performing ASX300 chief executives have shares valued at roughly 25 times their base income, but when it comes to my small cap selections the figure jumps to 32 times (see tables).

Ownership as a multiple of base salary

Executive remuneration is usually comprised of a base pay, and then short and long term performance-based incentives. For the purposes of this study we are just looking at the base pay, acknowledging that it is also important to assess that the hurdles for performance based remuneration don’t conflict with shareholders.

There is also merit in assessing the level of combined director ownership, as well as the chairman. However as expected and backed up by extensive studies from Guerdon, it is the level of chief executive ownership that has the largest impact on long term share price performance.

Below is the top ASX300 non-resources performers measured by a 10-year annualised total return to June this year.

Code

Company Name

Share price

10 year annualized total return

REA

REA Group

$46

49.8%

TOX

Tox Free Solutions

$3.26

43.6%

WEB

Webjet

$2.88

37.6%

MND

Monadelphous

$16.66

34.6%

CMW

Cromwell Property

$0.99

32.9%

MMS

McMillan Shakespeare

$9.56

32.6%

FRI

Finbar Group

$1.62

29.2%

HSN

Hansen Technology

$1.31

27.6%

JBH

JB Hi-Fi

$18.62

27.1%

RHC

Ramsay Healthcare

$45.77

27.1%

For those same companies the high level of chief executive ownership is clear with an average 25.3 multiple of base pay.

Code

CEO/MD

Current ownership ($)

Ownership %

Base Salary ($)

Ownership as a multiple of base salary

CEO/MD Start date

REA

Greg Ellis

1,847,820

0.03%

701,530

2.6

2008

TOX

Stephen Gostlow

4,860,699

1.1%

470,099

10.3

2005

WEB

john guscic

314,407

0.13%

574,999

0.5

2011

MND

Rob Velletri

41,650,000

2.7%

856,554

48.6

2003

CMW

Paul Weightman

15,761,955

0.9%

775,630

20.3

1998

MMS

Michael Kay

7,761,802

1.1%

1,001,595

7.7

2008

FRI

Darren Pateman

3,769,204

1%

424,318

8.9

2008

HSN

Andrew Hansen

52,989,113

25.1%

598,670

115.9

2000

JBH

Terry Smart

18,639,197

1%

1,580,880

11.8

2010

RHC

Christopher Rex

56,474,367

0.6%

2,100,000

26.9

2008

Average

20,406,856

25.3

Similarly the worst ASX300 non-resources performers below over the same 10-year timeframe are in the table below.

Code

Company Name

Share price

10 year annualized total return

FUN

Funtastic

0.06

-28.6%

AVG

Australian Vintage

0.335

-21.2%

BBG

Billabong

0.475

-18.4%

TEN

Ten Network

0.275

-16.6%

PMP

PMP Ltd.

0.455

-11.5%

VAH

Virgin Australia

0.425

-11.1%

PBT

Prana Biotech.

0.24

-10.5%

APN

APN News & Media

0.74

-10.0%

AOG

Aveo Group

2.06

-9.34%

PBG

Pacific Brands

0.55

-9.29%

 The corresponding low level of chief executive ownership for the poor performers can be seen with only a 1.2 average multiple of base salary.

Code

CEO/MD

Current ownership ($)

Ownership %

Base Salary ($)

Ownership as a multiple of base salary

CEO/MD Start

FUN

Stewart Downs

160,367

0.4%

484,985

0.33

2009

AVG

Neil Mcguigan

150,000

0.2%

599,339

0.25

2010

BBG

Launa Inman

28,025

0.006%

1,284,000

0.02

2012-2013

TEN

Hamish McLennan

860,750

0.12%

1,400,000

0.61

2013

PMP

Peter George

42,142

0.03%

600,000

0.07

2012

VAH

John Borghetti

817,828

0.06%

1,649,000

0.5

2010

PBT

Geoffrey Kempler

4,274,640

3.7%

426,466

10

2005

APN

Michael Miller

74,000

0.01%

1,200,000

0.06

2013

AOG

Geoff Grady

1,061

0.0%

470,000

0.002

2013

PBG

John Pollaers

0

0.0%

1,122,375

0

     2012

Average

640,881

1.2

While the correlation is strong there are a couple of complications to be aware of. With the top performers the chief executives are naturally going to have larger ownership due to the bonus performance shares they accrue along the way. So to some extent, it may be the performance that is causing the share ownership rather than the other way around.

With the poor performers, it may have been past chief executives who did the damage, and therefore we need to go back and check their level of ownership.

However, there is no doubting that over the long term, the boards that have governance in place for a certain level of chief executive ownership outperform those companies who don’t.

It is also clear that investors need to be wary of companies where the chief executive has a high base salary and minimal or no share ownership.

Equity Always Matters 

Although completed some time ago, Guerdon completed a detailed study of the correlations between various components of chief executive share ownership and performance for ASX300 companies.

The highlight of the study was that the 10-year annualised total return was highly correlated with the dollar value of the chief executive’s ownership.  The correlation was 0.46, compared to a weak correlation of 0.1 for the same study with a 1-year return. This result led to the conclusion that the CEO alignment with shareholders positively influences longer term strategic decision making:

Although some ownership is a positive, there needs to be some caution when the level of ownership gets too high as a percentage of the market cap. For one, the stock liquidity takes a hit. Also, there is a potential conflict between trying to maintain the high control, versus a focus on decisions that will enable the best chance of earnings and share price growth.

The Guerdon graph of the high correlation between the value of chief executive shares held and the average 10-year total shareholder return can be seen below.


Graph for The hidden power of CEO stock ownership

Source: Guerdon Associates    -  Value of CEO Shares Held vs Avg 10-yr TSR

Eureka Share Recommendations

From the 13 small cap companies I have recommendations for; there is generally a high level of chief executive ownership.  Indeed, industry surveys have regularly shown small companies are more likely to have bosses who own a larger percentage of the company's market capitalization. 

Within my selection of small caps at Eureka Report, Pental (PTL) and Energy Action (EAX) are exceptions to this rule but only for the moment as both chief executives only arrived in their posts in the last six to nine months.

The chief executive ownership of CTI Logistics (CLX), Vita Group (VTG) and Azure Healthcare (AZV) is at a level that has a negative side effect on stock liquidity – yet they are all exceptionally well run companies to partly offset that.

An example of the risk with an uncomfortably high ownership can be seen with Vita Group (VTG). The company’s boss, Maxine Horne, jointly owns her 46.5% stake with ex- joint chief David McMahon, despite McMahon leaving the company in 2013. This overhang may be part of the reason the stock is trading at a large discount to our valuation.  

For a company such as Capitol Health (CAJ), which is about to take on additional risk by expanding into the NSW and Queensland markets – shareholders can take some comfort that the value of John Conidi’s shareholding is 47 times that of his annual base salary, yet his shareholding is only 7.5% of the market cap.  

Company

Code

Share Price

CEO/MD

Current ownership ($)

Ownership %

Base Salary ($)

Ownership as a multiple of base

CEO/MD Start date

CTI Logistics

CLX

$2.03

David Watson

59,872,317

45%

439,883

136

1995

Pental

PTL

$0.033

Charlie McLeish

0

0%

400,000

0

2014

Energy Action

EAX

$3.05

Scott Wooldridge

0

0%

330,000

0

2013

UXC Ltd

UXC

$0.73

Cris Nicolli

2,721,160

1.2%

643,530

4

2010

Tox Free

TOX

$3.30

Stephen Gostlow

4,860,699

1.1%

470,099

10.3

2005

Azure Healthcare

AZV

$0.34

Robert Grey

18,455,739

30%

222,744

83

2011

Vita Group

VTG

$0.77

Maxine Horne

50,696,093

46.5%

574,625

88

1995

Empired

EPD

$0.63

Russell Baskerville

5,731,257

9.6%

360,000

16

2005

Mobile Embrace

MBE

$0.20

Chris Thorpe

5,335,328

7.2%

320,000

17

2001

Qube Logistics

QUB

$2.31

Maurice James

13,561,675

0.56%

728,000

19

2011

Brickworks

BKW

$14.40

Lindsay Partridge

3,847,522

0.18%

1,168,694

3

2000

Genera

GBI

$0.31

Lou Panaccio

60,000

0.23%

66,055

1

2011

Capitol Health

CAJ

$0.47

John Conidi

15,171,213

7.6%

321,539

47

2006

Average

13,870,231

32.6

Conclusion

In summary, there is clear evidence that the level of chief executive ownership has a direct relationship with long-term share price performance.  When assessing the alignment with shareholder interests, it is important to consider the governance policy regarding both director ownership and the link to remuneration.

Whilst these factors are important across the wider market, we think it is especially critical for undiscovered smaller companies.

Smaller companies usually involve more uncertainty and greater key man risk. The reason for large ownership is often because the founder remains in charge. Lastly, ownership at the smaller end is more likely to be from the managers purchasing stock themselves, rather than being given shares via performance-based incentives as often occurs with larger companies.

The size of the management team and the level of governance directed from the board is also usually lower at the small end – meaning the chances of a small cap been a 10-bagger or going to zero are highly dependent of the performance of the chief executive.

This is why for any of our small or mid cap recommendations, we ensure director and particularly chief executive alignment before concluding the stock is a BUY.

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