I have been in the investment business for more than two decades. In that time, I’ve heard many debates about the relative importance of high levels of insider ownership. The arguments against it are indeed compelling.

#-ad_banner-#First, management may own so much stock that they feel compelled to aggressively talk up a company’s prospects, solely to boost the value of shares. Second, when management controls a lot of stock, they may start to ignore the wishes of outside investors and take steps that enrich themselves ahead of other shareholders (such as board-approved excessive compensation levels). Lastly, a high concentration of shares in the hands of a few may lead to thin trading floats, which boost volatility and bid-ask spreads.

My view: high levels of insider ownership are mostly a good thing, because you want management to have the same goal as you: a higher stock price.

But I was never fully convinced of that view, until I came across a landmark study on the topic. A pair of finance professors (hailing from Sweden and Germany) found that “investing in firms in which the CEO owns a substantial fraction of shares (for example more than 10% of outstanding shares) leads to large abnormal returns.” Their study appeared last year in the Journal of Finance, which requires a subscription. You can read a free summary of their analysis here.

These two professors studied U.S. market data from 1998 until 2010 and found that companies with high insider ownership outperformed index benchmarks to the extent that management had strong control over business outcomes.

Specifically, when a company operates in a “value-oriented” sector, such as manufacturing, gains were in the 3.5% range. The idea is that management can’t do a lot to change industry supply and demand dynamics. However, in industries, such as technology, where CEO decision-making can have a huge impact, the benefits of high insider ownership yield a roughly 6% gain, relative to the broader market.

Another twist: the higher the level of ownership, the greater the returns. For example, owning more than 5% of stock boosted gains by 5.7% annually, while increasing the ownership threshold to 10% or more led to 6.2% annual outperformance.

The professors suggest a fairly mundane explanation for the outperformance: “abnormal returns for high CEO-ownership firms are high because CEOs have better information about the prospects of the firm.” That suggests this metric is especially useful with smaller capitalization stocks, which are more likely to be misunderstood (or under-appreciated) by Wall Street analysts and hedge fund managers. Looked at another way, it’s hard for an insider to own a major chunk of a company if that company is quite large and well-known.

Put In Play
How do you apply this approach to your investing style? First, it pays to see how much insiders own of each company in your portfolio. Insider tracking services, such as InsiderInsights.com provide a wealth of insider-related data on a ticker-searchable basis.

You can also use this approach to find stocks for further research. For example, you can visit a site such as Finviz.com and use their stock screener to look for companies with high insider ownership. As a test of that screening software, I looked at the field of small-cap stocks (market values of $300 million-to-$2 billion) and focused only on stocks with at least 100,000 shares in daily trading volume. (You don’t want high levels of insider ownership to lead to a tiny trading float.)

Leading this group happens to be a company I have been heavily researching lately: Kronos Worldwide, Inc. (NYSE: KRO). Kronos is one of the world’s leading producers of titanium dioxide, which is used as a tint in many paints and coatings. More than 80% of this company’s stock is owned by the estate of legendary investor Harold Simmons, who died at the end of 2013.

At the time, analysts at Citigroup noted the increased likelihood of a sale of the company as Simmons’ executors sought to simplify his estate. Shares initially spiked on the news, yet have now fallen to levels that may truly induce acquisition interest. Even in the absence of a buyout, shares are a deep value, trading at 12.5 times projected 2015 profits.

Other firms with high levels of insider ownership and appealing valuations include:

Intelsat S.A. (NYSE: I) — This satellite communication provider is 63%-owned by investment firm BGC Partners and trades for around eight-times annual earnings.

Southern Copper Corp. (NYSE: SCCO) — I profiled this copper firm six months ago.

First Bancorp (NYSE: FBP) — Management owns roughly 50% of this Puerto Rico-based lender, which trades right at book value.

Risks To Consider: Keep an eye on insiders’ moves. While researching this article, I noticed a high level of insider ownership at entertainment firm Scripps Networks Interactive, Inc. (NYSE: SNI). I also noticed a current high level of insider selling, which fully negates the virtue of high insider ownership.    

Action To Take –> You should always be aware of insider ownership levels at the company’s you own, along with the companies you are tracking. If a company’s management already owns more than 5% of company shares and is buying more stock on the open market, then consider that a clearly bullish signal that shares are undervalued, better days lie ahead, or both.

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