The hidden power of CEO stock ownership
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.
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.