Rule #1 Finance Blog

With Investor Phil Town

Watch Out for These 6 Red Flags of a Bad CEO When Investing in a Stock

When you start investing in a company, it’s important that you take a good look at the people who run it. You have to make sure that their management team has talent and integrity. Otherwise, they’ll run the company into the ground and you’ll be in danger of losing your money.

You get a sense whether the management team has integrity or not by reading the CEO letters or by looking at their report to you—the shareholder—and how they answer the questions at the quarterly or annual report. You can feel whether they see themselves as completely responsible to you as the owner, or if they are just giving you the report because they are obligated by law.

And by reading these reports, you get to see if they are making an effort to explain things to you in a way that you can easily understand them.

Small shareholders often assume that it’s their fault that they don’t understand CEO reports. However, this is not always the case.

When you can’t understand those quarterly reports, it’s because the management team is intentionally misleading you by using unclear language to cover up the fact that the company might be in trouble or they simply don’t understand their own company enough to explain it.

Whatever the case may be, the simple truth is that the company’s management team is just not interested in explaining things carefully to you.Blog-Sidebar-CTA--365x446-px

In some cases, you, the shareholder, might not really understand what the company is all about. In either case, you shouldn’t start investing in something you don’t understand because at that point, you’re just gambling. Investing is not gambling.

So as an investor, how do you know which companies to stay away from? How do you know if the CEO has talent, integrity and your best interests at heart?

Here are 6 signs of a bad CEO who does not have your best interests in mind. Avoid companies with this type of CEO running them.

1. Their paychecks go up with the size of the company’s assets.

The first sign to look for is if their paychecks go up with the size of the company’s assets. If the CEO goes out and acquires a bunch of companies to increase ‘value’ so they can pay themselves more, all while equity, and return on investment capital are going down and debt is increasing, you’ve got yourself a bad CEO.

Warren Buffett for example, is one of the lowest paid CEOs among American companies according to this article.

2. They have very little invested in the company stock.

If a CEO has very little of their personal net worth invested in company stock, that’s a bad CEO. When a CEO is earning four or five million dollars per year but they are not putting their own money in the company, that is a big warning sign. This means they do not have a stake in the company or the trust that it will do well.

A good CEO has most of his net worth in the company he is running.

3. They add size, but not return.

One of the biggest red flags is their acquisitions adding size, but reducing return on equity. This one is a bit tricky to spot. Although it may look like the company is getting bigger because of the CEO’s efforts, the truth is they are not adding anything of real value to the company. Instead, they might be adding a lot of debt.

This is because most CEOs nowadays are paid in assets. The more assets they have, the bigger their paycheck would be. Because of this, only adding to the size of the company will make its equity could go down.

If you see this, you should question the CEO’s goal. They are telling you they are on your side, but their actions indicate that they are trying to build their own empire on your money.

4. They sell corporate stock and tell you it’s “undervalued”.

A bad CEO sells corporate stock and says the stock is “undervalued.” Let’s say the CEO got a secondary offering and sells the stock at $.75 cents a share, but the stock is originally worth $1. That’s criminal!Blog-Sidebar-CTA--365x446-px

CEOs cannot squander what shareholders own by selling three-quarters of what it is worth. If they are willing to do that, the CEOs are getting rid of shareholders’ net worth at a discount. This is not a CEO with integrity.

5. Their shareholder letter sounds like a sales pitch.

Next, pay attention to the CEO’s shareholder letter sounding more like a pitch. He’s basically writing you letters without telling you what’s really going on with his company. Warren Buffett said if a CEO is willing to mislead others in public, it is very likely that he’s misleading himself in private. In other words, the CEO is a liar.

A good CEO tells it like it is.

A good CEO writes a letter every year that tells you enough about the company. He tells you the facts about the business so you can judge its appropriate value for yourself.

6. The CEO focus on EBITDA as if it were free cash flow.

The last sign to look for is the CEO focusing on earnings before interest, tax, depreciation, and amortization (EBITDA) as if it were free cash flow. If a CEO tells you in their quarterly report that paying interest and taxes, and the actual depreciation of the assets don’t have a material impact on the value of the business, nothing could be farther from the truth.

All of those things have a critical impact on the value of the business. When the CEO excludes them, they are artificially giving you a high valuation of the business on purpose because they lack integrity. They are just trying to bolster their own ego and options

A good CEO focuses on the free cash flow in the business, not on EBITDA.

If you see any of these red flags when researching CEOs of businesses you want to invest in, they are not worth your time and it’s best to move on to the next business.

Bottom line. Know the company you’re investing in, and know who’s running it.

Have you ever been burned by a CEO who was just flat out lying to shareholders about the state of a company before? We all have to make sure that we understand the company as if WE were the CEO. When you do that, you’ll give the actual CEO no excuses if they’re being dishonest with YOUR money.


Phil Town is an investment advisor, hedge fund manager, 3x NY Times Best-Selling Author, ex-Grand Canyon river guide, and former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo, and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence.