Company Focus4/11/2007 12:01 AM ET
CEO mansions: A stock indicator?
When a company's chief buys a big estate, the stock is about to tank. At least that's what two university researchers say. Here's how the correlation works, and some rather startling examples.

By Michael Brush
Forget everything you've learned about picking stocks (for a minute, anyway).

Instead, keep your eyes on high-end real estate sales and what I'll call the CEO Home Purchase Indicator.

Here's the idea: Whenever chief executives spend like kings on palatial mansions, it's a good sign their stocks are about to hit the skids. Stock picks based on that theory and held for three years beat the market by an average 46%.

The logic goes something like this: CEOs willing to spend outrageous money on housing aren't concerned about their job security or a watchdog board of directors, meaning they may not be working as hard as shareholders would like.

That's according to recent research by finance professors David Yermack of New York University and Crocker Liu of Arizona State University, who recently examined the link between the size of CEO homes and stock performance.

Here are a few of the more stunning examples of how the imperial CEO Home Purchase Indicator could have helped you make money in the market.

A contrary indicator
Let's start with Power-One (PWER, news, msgs), which makes power-conversion devices for telecom equipment that helps power the Internet. Back in August 2000, Power-One's then-CEO, Steven Goldman, moved in to a luxurious 11,800-square-foot, six-bedroom, seven-bath home in Malibu, Calif., complete with a swimming pool.

The house, not too far from the company's Camarillo, Calif., offices, was recently assessed at $3.3 million, and it's on 1.2 acres recently valued at $13.2 million, according to HomeInfoMax, which helped me research home values for this column.

Power-One stock traded north of $86 a share the year its CEO moved into his Malibu mansion and closed out the year at $39.31, adjusted for splits. But by September 2001, the stock had sunk below $5.50.

Power-One writes it off as a coincidence, explained away by the Internet stock crash at the time. "I think everyone understands that in the 2001 time frame the whole market corrected because of the Internet bubble, and Power-One is one of the stocks that got hit hard," says Dave Hage, who handles investor relations for Power-One. "I think they were stretching in their research, but so be it."

But this indicator doesn't just work with busted dot-coms. You could have made as much as a 45% gain by shorting Hilton Hotels (HLT, news, msgs) in the late 1990s after Hilton's chief executive, Stephen Bollenbach, purchased a 12,854-square-foot house on 2.9 acres in Los Angeles. (By going short, investors sell a stock they do not own, hoping it declines so they can buy it back and replace it at a lower price in the future.)

David Perdue took the reins at retailer Dollar General (DG, news, msgs) in April 2003. By 2004 he was building a 9,890-square-foot, six-bedroom, seven-bath dream home in Nashville, near the company's Goodlettsville, Tenn., headquarters. The home was recently valued at $2 million and is nestled on $829,000 worth of land, according to Intelius, an online database.

The year Perdue's house was built, his company's shares traded in the high teens and low $20s, and finished the year at $20.27. The stock started off strong in 2005 but then went into a steady slide, falling to $12 a share by Aug. 30, 2006.

The opposite indicator applies as well, according to the study. There may be no better example than Warren Buffett, the chief of Berkshire Hathaway (BRK.A, news, msgs), who still lives in a house he bought for $31,500 in 1958 in an ordinary neighborhood of Omaha, Neb. Berkshire Hathaway's share price has advanced 34,820% since the start of 1980.

Fat, happy and well-housed
What's going on here? After all, you might think that a CEO buying a mansion near the home office is a reassuring sign of commitment to the company. Instead, Yermack believes the purchase is a signal that the top executive feels "entrenched" and unafraid that the board may write a pink slip for mediocre performance. That kind of boss is less likely to feel pressure to work hard, according to this theory.

"It gives you some insight into the CEO's mindset," Yermack says. "An entrenched CEO perceives himself as immune from discipline by his board and is uninterested in maintaining or improving his performance to attract outside offers."

Yermack and Liu define a CEO home as extravagant if it is 10,000 square feet or bigger, or if it is on an estate of 10 acres or more. The two, looking back at 35 years' worth of data, sold stocks short when companies' CEOs bought mansions and bought stocks of companies whose CEOs bought humbler abodes. Over time, they simulated shorting 23 stocks and purchasing 141 stocks. On average, positions they added beat the S&P 500 Index ($INX) by 15% in the six months after the stocks were shorted or purchased, by 29.2% after one year and by 46% after three years.

"There aren't many investment strategies that do that well," says Yermack. "It is shockingly large in terms of what you see in financial research."

Stocks also tend to do poorly when CEOs finance a home purchase partly by selling the company's stock, even if the selling is relatively small. Yermack speculates that CEOs may be using the home purchase as an alibi for selling stock, when they are really selling because they see bad news ahead for the company.

Heavy lifting
Though online databases such as Intelius and HomeInfoMax have extensive national records of real estate transactions -- all part of the public record -- it's not always easy to find the CEO home purchases. Yermack and Liu found home purchases for CEOs at most of the S&P 500 companies. But they had to do extensive sleuthing in voter registration records, employment contracts and political-contribution databases to nail down many transactions with certainty.

One thing to consider: The CEO Home Purchase Indicator could keep you out of stocks that do phenomenally well over the long term. FedEx (FDX, news, msgs) Chief Executive Frederick Smith purchased a 10,320-square-foot home on 11.75 acres in Memphis, Tenn., in August 1986. The home and land were recently assessed at $3.4 million, according to Intelius. FedEx stock traded for around $15 at the time, adjusted for splits and dividends. But then it slipped below $9 by early 1988, a significant fall. It didn't close above $15 again until September 1993. So far, so good. But since then, the stock has taken off, advancing eightfold to close above $120 earlier this year -- all on Smith's watch.

At the time of publication, Michael Brush did not own or control shares of any companies mentioned in this column.