If the CEO Owns a Yacht, Should You Sell the Stock?

Photo: ferrettigroup.com

In the past, investors rarely cared much about off-the-job spending by CEOs. Who cared if the top dogs indulged in a yacht or Ferrari? It's their money, they can do what they want, right?

New research suggests that the yacht and Ferrari habits of CEOs could indeed be relevant to investors.

A National Bureau of Economic Research working paper by Robert Davidson, Aiyesha Dey and Abbie J. Smith found that companies run by free-spending CEOs are more likely to have accounting fraud, financial restatements and value-destroying deals.

Specifically, the paper looked at CEOs who owned a boat larger than 25 feet, a car priced at more than $75,000 or a home valued at more than twice the local median average. These CEOs, labeled “un-frugals,” were more likely to have material reporting errors at the companies they ran or other financial problems.

Think Dennis Kozlowski of Tyco

or Sanjay Kumar of Computer Associates, both of whom had large homes and yachts.

By contrast, frugal CEOs were more likely to have tighter financial controls and reporting systems at their companies, according to the research.

“Companies run by un-frugal CEOs are significantly more likely to engage in large acquisitions, to invest less in long-term organic growth, to operate assets in place less efficiently, to generate inferior subsequent accounting and stock-return per dollar of corporate investment, and to go bankrupt, suggesting a pattern of low frugality with regard to the stewardship of corporate resources,” the paper said.

The paper also found that un-frugal CEOs were more likely to have less independent corporate boards.

Granted, the research is preliminary. There are plenty of companies run by free-spending CEOs that do just fine. Consider Oracle, whose CEO Larry Ellison is famous for his mansion-buying habit and his large yacht. Oracle is doing just fine.

What’s more, there's no evidence in the paper that non-frugal CEOs are personally involved in fraud more often. It’s just that their companies are more prone to restatements and financial problems.

Robert Davidson, one of the study’s authors, said that there are two possible explanations for why companies run by free-spending CEOs are more likely to have restatements.

The “leisure theory” is that CEOs are too busy driving their fancy cars or cruising on their yachts to bother with constant details at the office. Toys can be distracting. And while CEOs may think they can run the company just as well from the Feadship, oftentimes they can’t.

The other explanation is the “lifestyle” theory. A CEO who needs large wealth and income to sustain his personal spending might place huge demands on the company for growth and profits. Sometimes those demands might be unrealistic, causing the CFO or others to push the envelope when it comes to reporting or accounting standards.

Mr. Davidson said it’s easier to explain why companies run by “frugals” – CEOs who don’t buy luxury toys – tend to stay out of trouble.

“We find that if people carefully monitor their own spending and are restrained in their own decision making, they will do the same on the job,” he said. "They tend to run a very tight ship."

Warren Buffett would certainly agree.

Why do you think companies run by free-spending CEOs tend to get into trouble more?

-By CNBC's Robert Frank
Follow Robert Frank on Twitter: @robtfrank