By Ben Strubel of Strubel Investment Management
I have been watching the saga surrounding Reverse Takeover (RTO) Chinese Small Cap companies with morbid fascination. Although we had and have no financial stake in any of the companies in our portfolios (our primary custodian, FOLIOfn, does not allow short selling and we certainly weren’t going long!) the ongoing saga highlights some powerful lessons for all investors--not just the ones caught up in Chinese RTO frauds. In the first part of this two-part series, we will look at lessons involving investor behavior and the role of auditors and large institutional investors. We can all learn from the mistakes of others. Here are 10 tips or lessons we can learn.
Start Off Being Skeptical and Not Trusting
Of all the behavioral biases humans have, perhaps none is more dangerous as confirmation bias. After making a decision, humans tend to seek out information that confirms that their original choice was the correct one and to ignore contradictory information. Once our opinion has formed people tend to view information or reports that confirm their decision as correct and those that don’t as wrong. Rather, we should objectively examine the new information.
Investors should start off being skeptical of all claims that management makes and have the attitude that a company is a bad investment until proven otherwise. The first thing I do when beginning research on an investment is seek out every negative article or research report I can find on the company. I also make it a point to talk to any analyst or fund manager that has sold the company short. Only once I have gathered all the negative information on a company do I then start to think about whether all the information is true or is there is another side to the story that is worth researching.
Social Proof Has No Place in Investing
"You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right." –Ben Graham
In his book Influence The Psychology of Persuasion, Dr. Robert Cialdini relates an interesting story showing just how bizarre a phenomenon like social proof can be. There was a cult in Chicago that believed aliens were coming at midnight on a certain date to take the members away from a flood that would destroy the world. On the appointed night when they gathered in the leader’s home, nothing happened. Faced with undeniable proof that their original beliefs had been incorrect, they did something that seems strange. While they had previous been relatively secretive and shunned the media and made no effort to attract recruits, they now began spreading their message in earnest. They began massive efforts to attract new recruits and regularly began contacting media outlets to spread their message. Why did they do it? They had gone too far and given up too much. They could not face the possibility that their belief was false. Many had quit their jobs and given away their life savings and possessions. To make that sacrifice seem worthwhile, the only proof left that they could muster up was social proof. That is, if they could recruit and convert many people, then they could surround themselves with others who believed as they did and could convince themselves that their sacrifices were not in vain.
While the story may sound bizarre, it is not so different than what many investors do. While confirmation bias keeps many investors from even considering contradictory information, even when the evidence is clearly overwhelming those investors do what the cultists did. Instead of having an intelligent discussion about the substantive issues, many shareholders take to the proverbial streets, in this case internet message boards or blogs, and begin seeking more recruits.
What should investors do instead? When the evidence becomes overwhelming that you are wrong, admit it and sell. The ending for most China RTO frauds follows the same pattern: a trading halt followed by a delisting from a major exchange before finally trading over the counter for a small fraction of the share price. But before their stocks met their end on the OTC market, many individual shareholders were faced with overwhelming evidence that they were in far over their heads. At that point they had the chance to sell with far smaller losses. Instead of admitting they were wrong, many chose to surround themselves with yes men who knew as much or less than they did.
Be an investor not a cultist.
If It Is Too Good to Be True, It Is
In a business environment that is more competitive than ever due to globalization, investors should be skeptical of any company earning outsized profits or growing well above industry rates. For a company to earn outsize profits in a competitive environment, it needs some sort of durable economic advantage. Examples include Philip Morris International whose strong brand name, habitual purchases by consumers and addictive product provide a moat. Microsoft can leverage economies of scale and high switching costs for its Windows and Office franchises to earn outsize returns. High growth comes from launching new and innovative products such as Apple and its many consumer electronic hits such as the iPod, iPhone, and iPad.
Contrast this with many of the fraudulent Chinese RTOs. They were in boring commodity businesses such as fertilizer, jewelry, industrial equipment, advertising, generic and/or eastern pharmaceutical sales that offered no competitive advantages. Management’s explanation for how the companies earned profits at three or four times industry averages were always weak and implausible. Some of the weak reasons were good cost control, good management, and various spurious special licenses or agreements.
If a company is wildly successful according to the financial statements it files and a whole slew of competitors who are trying to emulate it fail to make similar splashes, than the company deserves very thorough scrutiny.
Auditors Don’t Audit
“If only 20% of financial statement users think the auditor’s opinion is worthless, it means 80% of investors are dumb.” –Sam E. Antar via Twitter
Audits are designed to give investors reasonable assurance that the numbers reported on a financial statement are materially accurate. Audits are not designed to detect fraud, and audits are not designed to give absolute assurance that the numbers are accurate.
The Public Company Accounting Oversight Board (PCAOB) says: “Audits typically involve testing a sampling of data and exercising judgment about audit evidence – what to collect, how much is necessary, the extent and nature of testing, and the best way to gather it. Because auditors do not examine every transaction and event, there is no guarantee