Strong Management: What Makes a Good CEO for a Passive Income Investment
As an accredited investor looking for a passive income investment, we want to invest in a company with a strong management team. We’re most interested in the more senior level leadership of the company, as those are the people who set the ‘tone at the top’. On a publicly traded company we will be able to easily find information on the company’s management including the Board of Directors, Chief Executive Officer (CEO), Chief Financial Officer (CFO) and Chief Operations Officer (COO). The CEO is the person most responsible for the performance of the entire company, so we’ll start by evaluating the CEO. We’re looking to see if we think the CEO has a company-first focus, has the shareholder’s interests in mind when making decisions, and if we feel the CEO acts with integrity.
Since we’re not putting our money into a mutual fund where we rely upon a money manager, we need to be sure the CEO of the company we pick is made of the right stuff. We want the CEO to run the company well and take care of our passive income investment in the company. A CEO who acts with integrity is critical. We want to be sure the CEO lives and breathes the company. We don’t want a CEO who is distracted by self-promotion, such as giving interviews, writing books, or speaking engagements. These types of activities are done to draw attention to oneself, not improve the company. We want someone Jim Collins would call a Level 5 leader, a humble person who gets fulfillment from the performance of the company they lead.
We want a CEO who is passionate about their company, honest, and has the owners of the company (the shareholders) in mind when making decisions. When looking at a CEO I like to do an internet search on the CEO’s name (Google, YouTube) to see what comes up outside their current or former position. I also like to read the CEO’s Letter to Shareholders in the company’s most recent Annual Report.
CEO Employment History
A stable, strong management team is more likely to be successful than a management team that consists of short-term employees looking for their next individual opportunity. We want the leader to be with the company for the long haul, willing to weather any storms that may arise to help the company come out stronger on the other side.
A CEO who is the founder of the company is more likely to have a long term interest in the success of the company than a new CEO who has been job hopping, spending a few years at one company before moving on to the next. A CEO who is not the founder could still be a good CEO, but we want a person who has a long, stable job history, preferably at the company they are currently leading. If the company is a cyclical company, we want the CEO to have been with the company long enough to have experienced the company’s last downturn and understand the steps the company needs to take while its business or industry cycle plays out.
Research the CEO’s job performance in his or her current and prior positions when considering a company for a passive income investment. If the CEO has been a CEO or senior leader before, how did the company perform? Did the share price tank at the last company the CEO ran? If the CEO was a COO at the current company prior to filling the CEO role, how did the company improve their operations under the leadership of this individual? While not perfect, past performance can help predict future performance.
CEO Ownership of Company Stock
One way to measure the CEO’s commitment to the company is by looking at how many shares of the company’s stock the CEO owns. This is different than the stock options the CEO has. A stock option is something the CEO can exercise that doesn’t cost the CEO anything, and the stock options should be a condition of meeting certain performance criteria. We would prefer a CEO who owns actual shares of the company. The CEO should own enough shares of the company that it represents a significant portion of his net worth. We want the CEO to be concerned about the long term performance of the company and the company’s share price. We also want the CEO to be holding their shares or buying more, not selling them.
The way I research how much company stock leadership owns is GuruFocus. GuruFocus shows the overall history of insider trades for the company, including how many shares have been purchased and sold by each insider, how many shares are owned by each insider, the date and price for each insider transaction, and also a summary of the total number of trades and total number of shares purchased and sold by all of the company’s insiders. I like to use this to help me identify a trend of several insiders buying or selling shares. The insiders know more about what is happening at the company than I do, and if company management is selling shares of company stock, I would dig a bit deeper to figure out why those insiders are selling their shares before I invest in the company to generate passive income.
When researching an executive’s stock sales keep in mind that some executives use their stock option contracts as income. It is common for senior leadership to sell a small amount of their shares consistently as their stock options vest, so it isn’t alarming if an executive is selling shares but the number of shares the person holds is consistent. If an executive sells over 20% of their shares then I look to see if other executives are doing the same. If they are, then I look a little further into the company to try to figure out why. Is there a lawsuit coming? Is this a cyclical industry/company? What could happen that would cause the share price to drop in the near future?
Share Buybacks
Is the company doing share buybacks under the current CEO? If so, are the share repurchases at a reasonable price, or when the stock is trading near an all-time high? Share buybacks can give insight into the motivation of a CEO. A CEO who wants to boost the share price can allocate funds to share buybacks, and as the company re-purchases shares the share price should increase.
While stock buybacks can appear to be good for shareholders, we do not want the CEO to be doing share repurchases when the shares are overpriced. If the shares are trading at a price that is greater than what we feel the shares are worth, then those funds could be allocated more effectively to capital expenditures in a way that would help the company grow, which would help the share price over the long term. That could be an investment in machinery, building a new facility, an acquisition, etc. The company should only be doing share buybacks if they do not have a better use for the money, and share repurchases should only occur using cash on hand. Our passive income investment should not be in a company financing share repurchases with debt.
Company CEO Research Checklist
Here is a checklist for researching the CEO of a company you thinking about using to generate passive income:
- Is the CEO the founder?
- When did the CEO become CEO?
- What prior positions did the CEO hold, and for how long?
- Is the CEO stable, or bouncing around to several different companies?
- If the CEO was at other companies, how did those companies perform with this person as the CEO?
- How many shares of company stock does the CEO own?
- Is the CEO buying or selling shares of the company’s stock?
- Is the CEO’s pay reasonable when compared with other CEOs in the industry?
- What metrics determine the CEO’s bonus and vesting of stock options?
- Is the CEO serving on other company boards? If these are non-profit companies I’m ok with that, if the board is of a traditional for-profit company, what is the CEO getting out of it? This could be a distraction from what should be the CEO’s focus of delivering value for shareholders. I would prefer a CEO that is not moonlighting to one that is.
- Is the CEO in magazine articles, giving interviews, commenting on current events, writing books, speaking at events, or doing other things that distract the CEO from his/her number one priority, which is running the company?
- Does the CEO’s annual letter to shareholders in the annual report help me understand what the company is doing and the direction it is headed, or is it fluff? Does it say both good and bad things?
- From one earnings call to the next, does the message from the CEO stay consistent? Are they changing the metrics they discuss on earnings calls?
- Does the CEO do what he says he will do?
- Do I trust the CEO with my investment?
- Is the company doing stock buybacks? If so, are share the shares trading at, below, or above our per share valuation of the company?
- How much cash does the company have on hand compared to revenue? Is this increasing or decreasing?
- Does the company have enough cash on hand to pay off their debt?
- Is net debt to free cash flow increasing, decreasing, or staying the same over the last five years with this person as CEO?
- Are dividends, share buybacks, capital expenditures increasing, decreasing or staying the same?