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March 12, 2013

The Entrepreneur & The Stock Market Investor Are Two Very Different Animals

by François Sicart.

Be careful of the signals that you read into selling by corporate insiders: not only do these individuals have different objectives in mind, they view the world in a very different way.

Recent media reports, such as an article in Barron’s, have drawn attention to what they describe as a surge in stock market selling by corporate insiders at what may be two or three times the normal pace. Traditionally, this has been interpreted as a negative signal for stock prices. Who better than insiders would know when to buy or sell? But things are not always that simple.

The Insider and the Appraiser

First of all, there always are more inside sellers than buyers, maybe four or five times as many. In part, this is due to the existence of large historical holdings that tend to serve as a regular source of cash for the founders of the business or their heirs. But this selling by insiders also is, in part, a result of the huge increase of options and other equity-based schemes in recent years. This has meant that executives need to sell stock to realize some of their compensation.

In any case, I have never been particularly impressed with the stock market acumen of corporate executives. For example, I have seldom met corporate chieftains who failed to find their stock “cheap,” whereas, as a value investor, I view stock cheapness as a rare and precious occurrence.

Generally, strong executive insider trading is most useful as an investment guide when it seems to contradict the market consensus view of a company’s stock. The ideal buy signal occurs when a stock has been declining or stagnating for an extended period of time (long enough for a majority of investors to become discouraged), and a number of executive insiders begin accumulating shares, indicating that the business may be improving. The reverse applies to sell signals – though, as usual, with a somewhat greater lag between signal and event.

Also, note that it is important to look at the number of insiders buying or selling, rather than at the total volume of shares traded. Large shareholders may have other motives for selling, such as patrimonial diversification or the purchase of real estate for their children. Non-executive board members may not feel the pulse of the business as operational personnel might. But several clustered trades by operational managers, even if smaller in size, may carry a useful message.

But the overarching truth is that while businesspersons know most about how well their business is doing, but they are not necessarily good (in fact, rarely so) at judging how much it is worth. In particular, many academic studies, as well as my own experience, remind us that a business that is currently doing well is not necessarily an attractive stock market purchase. Depending upon how well recognized its success is by the investing crowd, most of the good news may already “be in the price” of its stock. For budding investors in the stock market, it is good to study history and to realize that companies that change the way the world works, as railroads, airlines, or radio did in their time, do not always prove profitable investments for their early investors.

The Meddler and the Referee

The difference between investing in the publicly traded shares of a business, on the one hand, and owning and/or running an enterprise on the other, is a bit like the difference between dating and marriage. It is a matter of the depth and length of the commitment.

If an outside investor disagrees with the way a company is run, he or she has an easy way out: sell the stock and find a better idea. The business owner or chief executive does not have that luxury. Not only is it complicated to sell a private business or corporation, especially in a lukewarm environment, but also it is not in the entrepreneur’s nature as a born meddler and fixer to give up on his or her company. Entrepreneurs are not only optimists; they are stubborn optimists. Not surprisingly, they will normally spend a good part of their time on the offensive, devising ways to gain market share from competitors.

However, while it is in the nature of entrepreneurs to take risks, they seldom bother to calculate if they are properly compensated for the risks they are taking. That’s due, firstly, to the fact that they are inveterate optimists and secondly, to the fact that they believe they are the masters of their business’s destiny.

Good stock market investors tend to focus more on the defensive. Most of them know that even successful investing is fraught with occasional missteps. In contrast to the entrepreneur, who constantly bets that he or she will win by making the right decision, the stock market investor aims first for fewer costly mistakes, proper diversification, and, in the end, a good overall batting average. At Tocqueville, for example, my partner, Robert Kleinschmidt, has instituted a team of skeptics among our research staff, whose role it is to punch holes in the favorable investment recommendations of their colleagues.

To quote Warren Buffet: “Rule No.1: Never lose money. Rule No.2: Never forget rule No. 1.”

Different Response Times

In financial investment, I find the quality of contrarianism to be extremely valuable. If your idea is basically correct but your timing is not perfect, as is often the case for value investors, you have a good chance of being bailed out by time – in the next phase of the business cycle or even in the next business cycle altogether. And if the stock has declined in the meantime, you are given an opportunity to buy more shares at a cheaper price.

In contrast, being a contrarian in business (at least a systematic one) could prove fatal. If, at the beginning of a down cycle, you accumulated too much time-sensitive or fashion-oriented inventory, or invested in too much new equipment, then losses, and possibly a severe liquidity squeeze, are likely to follow. In business, time seldom bails you out.

Some successful CEOs are long-term planners, but by and large I believe more of them are fast movers. They are prompt when it comes to recognize new trends for their businesses and very quick to adapt when necessary, or to identify and seize new opportunities. For this reason, despite their theoretically longer-term time commitment, business owners/executives tend to have better instincts for trading than for stock market investing. But in my long stock market experience, few long-term fortunes were made by short-term trading.

Let Each One Do What He or She Does Best

One of my earliest clients was a highly successful art dealer specializing in Old Master paintings. Beyond his obvious ability to locate and purchase great art, he was an outstanding entrepreneur. He used to tell me, “You will never make as much money for me as I will myself…but you are second best.” This was a fair assessment.

The primary goal of an entrepreneur is to create a fortune, in part by taking significant risk when necessary and when the potential return warrants it. The goal of an investment manager is to protect a patrimony against (or through) economic, political, or financial crises – as well as against the loss of purchasing power due to inflation. With the right discipline, this patrimony should also grow over time.

But the successful entrepreneur and the successful investment manager have different skill sets and instincts. Good judgment demands that one should not attempt to practice in the other’s field of excellence.

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