It Pays to Have Skin in the Game

It matters whom you get into bed with.

That’s true in relationships, both figuratively and literally. It’s true in business. And it’s true in investing as well.

That’s why I stress the importance of a company’s management so much. Because when you buy a stock, you don’t just purchase a set of lifeless shares.

You buy into humans, complete with their own mindsets, strengths, and weaknesses. If you want to succeed, you have to know who and what those are.

This is a topic Warren Buffett addressed at his 1994 Berkshire Hathaway (BRK-B) shareholder meeting. He advised investors and potential investors to “look at what [management has] accomplished, considering what the hand was that they were dealt when they took over compared to what is going on in the industry.”

Buffett added that you should also “see how they treat themselves versus how they treat [their] shareholders.” In other words, do they work harder to enrich their investors or themselves?

It might seem obvious that it’s best to avoid selfish management. But it’s easy to get caught up in a company’s concept or the cult of personality surrounding certain leaders.

That’s why I like to meet executives before I recommend a stock. I want to get a sense of who they are in person as well as on paper.

Of course, that’s a lot easier said than done for most people. So let me share another way to evaluate management’s commitment to their company and investors alike.

It all about whether they put their money where their mouths are.

Interests Aligned

Last week, I had a call with a friend who runs a large family office in southern Florida. A few business partners and I are looking to raise money for a private real estate fund in Latin America, and we’re seeking seed capital from his firm.

Now, this guy isn’t stupid. He runs a very successful business, and he knows that you need more than just a good personal relationship to cut a profitable deal.

So he asked me some hard questions, which I both expected and respected.

One of those questions was about whether there would be a suitable “alignment of interests.” He wanted to make sure that everyone involved – not just him – would have the same commitment to making the project work…

We all had to have “skin in the game,” he said, with compensation structures that motivated each player to not only benefit himself but the larger group as well.

Obviously, we’d all be putting money into the project. Obviously, we’d all be hoping to make it work.

But would we be putting in enough to make it hurt if we failed?

That’s the same kind of question you want to ask about CEOs, chief financial officers, and the rest of the C-suite team. Sure, they have their paychecks and their bonuses to incentivize them. But they can always find new jobs if their current ones don’t work out.

A real sign of commitment – and confidence – is when they invest in their own stock.

That means if your shares perform badly, so do theirs… giving them added incentive to make the wisest decisions possible for the company they run.

This isn’t a foolproof way of making money, mind you. Adam Neumann owned millions of shares of WeWork, for instance, and he still managed to run that business into the ground. So don’t forget to conduct all-around due diligence before you commit your hard-earned cash to any asset.

However, more often than not, when corporate’s interests are so aligned with yours, your long-term profit potential goes up.

Quite a bit.

Two REITs That Are Well Aligned With Their Shareholders

Two companies come to mind immediately when I think about management with skin in the game. And both are real estate investment trusts, or REITs.

The first is Agree Realty (ADC), a net-lease REIT that owns more than 2,400 properties. They’re leased to brands such as Walmart, Tractor Supply, Dollar General, and Best Buy.

I like Agree for numerous reasons, including its predictable cash flow that comes from its high-quality customer base. Plus, its disciplined capital structure consists of low leverage – with a 4.9 times ratio of its net debt to earnings before interest, taxes, depreciation, and amortization (“EBITDA”) – and investment-grade balance sheet, which is rated Baa1 by Moody’s and BBB+ by Standard & Poor’s (S&P).

Admittedly, there are other REITs that can say the same. What really sets Agree apart is how its founder, Richard Agree, and CEO, Joey Agree, own more than 1.27 million shares valued at around $95 million.

The company is also busy increasing its dividend track record, raising it at around a 6% compound annual growth rate over the past 10 years. And it maintains a safe payout ratio of around 75%.

There’s just a lot to like here.

My second “money where their mouth is” pick is Ladder Capital (LADR). It’s a mortgage REIT I featured on The Wide Moat Show last week.

Ladder’s management team also has considerable skin in the game with a collective 11% share ownership. That’s valued at around $160 million, all told.

These executives also have an average of 29 years’ worth of experience in their field, with an average company tenure of 13 years. And around 40% of their employees have been with the firm for more than 10 years.

All of this seems to indicate that Ladder is doing something right.

I speak with CEO Brian Harris regularly enough, and he tells me he’s actively involved in the REIT’s every transaction. He knows the details of each loan – which currently amounts to $1.8 billion – and every borrower.

Clearly, he has confidence in what he sees.

When a CEO cares that much about his or her company, that company typically warrants a second look. And for me, based on my further evaluation of both Ladder and Agree, they make strong companies to partner with.

Regards,

Brad Thomas
Editor, Wide Moat Daily