Cover Image for How to Avoid Investing in Corrupt Companies (Don't Get Burned By a Bad CEO)

How to Avoid Investing in Corrupt Companies (Don't Get Burned By a Bad CEO)

Phil Town
Phil Town

Nothing can sink a company and all of its investors quite as fast as corrupt companies, corrupt CEOs, or management teams.

You don't have to look very hard to find examples of CEOs and other executives who sent their companies into a tailspin due to shady deals, ethically questionable behavior, and corporate corruption.

This is why management is one of the 4 M's of Rule #1 investing and an important one at that.

Sometimes, though, it can be difficult to know whether or not the management of a company is trustworthy and if you’re investing in a corrupt company.

In this article, we'll take a look at a few tips you can use to highlight untrustworthy management and avoid investing in corrupt companies.

1. Are the Company Founders Part of Management?

As a general rule, the men and women who found a company originally are less likely to be corrupt than someone who is hired on to run the company.

There are a couple of reasons why this is the case, starting with the fact that the founders of a company normally have a large financial stake in its success; they can't afford to engage in corrupt behavior that could bankrupt it.

In addition to this, most founders are incredibly passionate about the company they started and wouldn't want to do anything that poses a risk to it.

Of course, these things are just generalities, and there are certainly founders out there who are exceptions to the rule.

However, if the founders of a company are part of its management then it's normally a good sign.

2. Is the Company Managing Debt Correctly?

And with integrity? How management goes about managing a company's debt says a lot about their integrity.

If a company's management is using debt as a way to artificially inflate a company's numbers and make it more attractive to investors, you should avoid putting your money into that company at all costs.

One of the main ways that management sometimes uses debt in this manner is by adding size to the company but not increasing the company's returns.

Since executives are often paid based on a company's assets rather than its returns, this is a great way for them to line their own pocketbooks, but it delivers little value to investors.

3. Does Management Have a Personal Stake in the Company’s Success?

Never invest in a company that is run by executives who do not have enough faith in the company to invest their own money in it.

If an executive does not have a significant portion of their own net worth invested in company stock, not only are they showing little faith in the company that they run, they also have little incentive to grow it and ensure that it is successful.

In other words, executives who have no stake in a company's success are just there to collect a paycheck, and this is almost always a recipe for disaster.

Good executives will trust a company and their own ability to grow it enough to put skin in the game.

If they don't have a large portion of their own money invested in the company, why should they expect you to invest a large portion of yours?

4. Are They Trustworthy?

Trustworthiness is perhaps the most important factor to consider when evaluating the management of a company.

It's also one of the most difficult to analyze.

After all, it can sometimes be hard to determine the trustworthiness of people you are close to, much less, people who you have never met.

How to Know if a CEO is Corrupt

With that said, there are things that you can look at to determine whether or not a company's management is trustworthy.

Start by researching their past career. Ideally, it will be squeaky clean and free of scandal, however, if an executive was willing to engage in corrupt behavior in the past, chances are they would be willing to do it again.

Next, take a look at the letter that the CEO sends out to shareholders.

Are they being honest about the state of the company, letting shareholders know about both the good news and the bad, or are they treating their shareholder letter like a sales pitch?

If it's the latter, the CEO is essentially lying to their shareholders and the public at large in order to sell more stock, and this is a huge red flag.

As Warren Buffet once said, if a CEO is willing to mislead others in public, they are probably misleading others in private as well.

Have you ever been burned by a corrupt company? If you have, you know why management is so important. If you haven't, you need to learn why it's one of the most important aspects of our checklist when picking companies to invest in.

How to Pick Rule #1 Stocks

5 simple steps to find, evaluate, and invest in wonderful companies.