Editor’s note: Today, you’ll hear from colleague Brad Thomas.

Longtime readers will remember Brad. He was a real estate developer who lost almost everything in the 2008 housing crash.

After that, he rebuilt his fortune with his “sleep well at night” investing strategy that focuses on building reliable income streams through the stock market.

And today he shares why, when investing in a company, it’s important you look beyond the company’s profits to the people managing it…

Because a company led by executives who care about their customers, employees, and shareholders – and not just looking good on earnings calls – will better help you reach your long-term goals.

Michael Jensen passed away in April. He was 84.

Readers may have never heard Jensen’s name before. But as an economist and Harvard Business School professor, he was very influential in certain circles… including mine.

One of the most memorable college courses I ever took was The Concept of Dividend Policy.

Dr. Arnold, who taught it, cited a study one day titled, “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers.” The study was one of Jensen’s. And it detailed an ugly truth…

When a company generates too much cash flow with no strategy on where to put it, members of management tend to misuse it.

Jensen’s analysis stuck with me through the decades, and it very much influences how I operate today. I’ll never forget how he argued that leaders of publicly traded companies too often focus on looking good from quarter to quarter.

The more focused they are on achieving flashy profits, the more apt they are to make huge mistakes. One way to curb that enthusiasm, Jensen proposed, is to channel appropriate amounts of cash into dividend payments.

“Payouts to shareholders,” he wrote, “reduce the resources under manager’s control, thereby reducing managers’ power” to essentially make stupid mistakes.

Now, I do want to highlight how he used the word “reducing,” not “eliminating.” As Benjamin Graham, the father of value investing, wrote in The Intelligent Investor decades before, “paying out a dividend” only improves “the return of the typical stock.”

It does not “guarantee great results.” So, you still have to do your due diligence into what the company does and how it does it.

And one of the best ways to do that is to dig past mere profits to see who’s managing them. To quote Jensen again, this time from a speech he gave years later, you need to seek out integrity. “Without it,” he said, “nothing works.”

At least not for very long.

Integrity Governs the Story

Jensen argued – accurately, in my opinion – that management integrity dictates so much of a company’s story. Obviously, since management is in charge of deciding:

  • Consumer targets

  • Product development

  • Product marketing

  • Corporate goals

  • Corporate culture

  • Capital allocation

If a company is led by executives who care about their customers, their employees, and their shareholders instead of merely looking good on quarterly earnings calls… investors are much more likely to achieve successful long-term gains.

In other words, you want to find executives with integrity. And I’ve made that an important filter in my own investments and in the research I provide to readers.

One example I like to point to is the team over at Realty Income (O). In the spirit of full disclosure, I would remind readers that I do own shares of this real estate investment trust, or REIT, and have been for some time.

I have good reason to be.

The company takes its shareholders so seriously that it copyrighted itself as “The Monthly Dividend Company®.”

There’s no going back from that level of commitment.

Led by CEO Sumit Roy, Realty Income describes its mission as delivering “stockholders dependable monthly dividends that grow over time.” That’s why it’s proud to say that, “Since our founding, we have declared 647 consecutive monthly dividends.”

I attended a conference in New York City this week – which I’ll tell you all about next week – where I got to talk to Sumit. He described Realty Income’s dividend as “sacrosanct to who we are.”

How does it get better than that? A CEO who describes his company’s dividend as sacred – including its track record of paying an increasing dividend for over 50 years in a row now (30 years as a public company).

It also stands by its commitment to “transparency.” And not just enough to suit the SEC, which it’s required to report to. It focuses on “high-quality commercial assets” suited to “industry-leading operators under long-term net-lease agreements” that produce steady, stable profits for the company and increasing dividends for shareholders.

Those aren’t mere words either. The proof is in its performance. A quarter century’s worth of reliable growth isn’t something companies easily achieve without it.

Unfortunately, I’ve also had my run-ins with executives who were lacking in that department.

Speaking of Immature Profit-Chasing…

Contrast that with American Realty Capital, another net-lease REIT that once traded under the ticker symbol ARCP.

I first noted it had a real issue on October 23, 2014, when I explained that I was very concerned with its “unusually high” dividend yield. It was far too focused on being “the world’s largest net-lease company” rather than on sustainable growth.

Nick Schorsch, then in charge, was producing phenomenal returns during the economic recovery… to the point of being suspicious. And his character was on full display a few days after I published my analysis.

I was at the gym when the CEO, David Kay, called me, furious that I’d dared to say his stock was a “sucker-yield.”

But I stuck to my guns that his dividend wasn’t sustainable. As I firmly told him, I cared more about my principle than his outrage.

And his other investors deserved to know as well.

It was mere days later that, sure enough, the REIT announced it had overstated earnings. Not long after, it slashed its dividend, sending the share price tumbling with it.

Worse yet, we soon learned that its CFO had been caught in “accounting errors” that would eventually land him in jail and force Schorsch to resign in disgrace.

The ultimate legal conclusion was that Schorsch had not committed a crime. And I’m fine accepting that conclusion. But CFOs don’t usually cook the books without feeling undue pressure from their leaders.

Schorsch did not run a quality company in ARCP, and recognizing it saved me – and my readers – from buying into more shares of this so-called “sucker yield.”

To me, that kind of loss is unacceptable.

Businesses That Deserve Your Capital

One thing I’ll tell readers frequently is to find businesses that deserve your investment capital. Many think it’s the other way around. They’re willing to make excuses for management that falls short or misleads its investors.

That’s completely backward.

An investment in any business is a statement of trust – first and foremost – in the managers of that business. And trust should never be given. It’s earned.

Every company experiences market bumps and bruises. So you’re never going to find a perfect investment.

But if you look for companies run by intelligent teams that emphasize integrity, you’re much more likely to find Realty Income-like opportunities. And avoid the ARCPs of the world, which is every bit as important.

For Professor Jensen, embracing integrity was extremely important. As he famously explained, “The most wonderful things happen if you have integrity.”

Regards,

Brad Thomas
Editor, Intelligent Income Daily