By Ben Strubel of Strubel Investment Management
In the first part of this article, found here, I talked about several behavioral biases investors have that keep them from recognizing fraud. I also discussed the futility of relying on auditors and institutional investors to do your research for you. In the second part of the article I want to talk about the lengths management will go to deceive investors, a few issues that are specific to Chinese companies, and the largely helpful role short sellers play in the marketplace.
Beware the Potemkin Village
Investors don’t seem to realize the lengths that some crooked management teams will go to defraud investors. Sometimes investors claim there is no way 20 or 50 or any large number of people could be in on a scam, but management may go to great lengths to fool investors. For example, in 1998 Enron launched Enron Energy Services, but the division wasn’t up and running yet. To fool analysts who were brought in for a tour, the company constructed a huge fake trading floor and “command center” complete with hundreds of thousands of dollars worth of computers, monitors, and phones. Secretarial staff and other employees were brought in from other floors to populate the trading floor. Enron even held a dress rehearsal the day before the analysts’ conference to ensure everything would go smoothly. As another example, take a recent article in The Atlantic about the Chinese practice of “renting” foreigners to pose as important businesspeople.
A favorite method of those doing due diligence is to tour a company’s facilities. But does a financial analyst or average investor really have the ability to discern a fake factory, operated only for tours, from a real one operating year round? Can a financial analyst or investor tell the difference between a production line that can produce 100,000 tons a year from one that produces 50,000 tons? Does a financial analyst know what a real fertilizer factory should look like? Can an analyst tell the difference between a one-million-dollar piece of equipment and a one-hundred-thousand-dollar one? The answer to these questions for the vast majority of analysts (especially those of the eternally bullish nature) is no. The facilities need to be evaluated by an independent expert in that company’s industry for the pictures or tour of the facility to have any substantial value. Of course, that’s not to say that some companies’ deceptions may be so poorly presented even a layperson can see many red flags and problems.
Reviewing company documents is also considered de rigueur for doing due diligence. But again are investors or analysts really in a position to discern a real bank statement from a fake one, a real commercial lease document from a fake one, or a real business license from a fake one. In most cases the answer is no.
One of the most important things investors can do to protect themselves from the scams, shams, and flimflams of management is to insist on verifying all company-supplied information with independent third parties. Never use management-supplied contact information. Say you want to verify a company’s distributor. Get the name of the distributor. Then do your own research to find its main number and call, so you are sure you are speaking to that distributor and not an imposter. Calling the number management gave you, could connect you with anyone.
Don’t use documents provided by the company either. Instead, attempt to verify what the company claims with an independent third party. Many businesses already do this. For example, when I opened a bank account for my business one of the documents I was required to provide was form or letter from the PA Department of State Corporation Bureau, proving the existence of my business. But the bank didn’t use that document to verify my business was legitimate. The copy of that document was only for bank files. Instead, my bank went to an independent third party, in this case, the Commonwealth of Pennsylvania and used its website to verify that my business existed and was registered correctly. There are a multitude of local, state, and federal government databases that investors can use to check up on any company’s claims. If you’re investing in a foreign country and are unaware of how to check up on management or unable to verify management’s claims, then perhaps you should stick to investing in areas where you can verify information.
When visiting a company, show up unannounced. Many fraudulent companies put on impressive looking displays for analyst days or investor tours. Scheduling a visit ahead of time also allows a company time to prepare and make sure its window dressing is ready or to come up with a convenient excuse about why that day doesn’t suit them. Showing up unannounced gives you a much better chance to see how the company operates day in and day out and makes it far less likely you will be viewing an elaborate deception. In fact, several short sellers have staked out or visited several Chinese RTOs and found the situations there much different than what investors and analysts saw on their guided tours.
In short, investors need to look to independent third parties to support management’s claims, and not rely on management themselves.
Answers, Not Excuses
“You don’t want another Enron? Here’s your law: If a company, can’t explain, in ONE SENTENCE what it does, it’s illegal.” –Lewis Black
“There was a misunderstanding…”, “We look forward to discussing…”, “The analyst never contacted our management to discuss…”, “we plan to pay a cash dividend…”, “the board authorized a share repurchase program…”
What do most of these phrases have in common? Besides being excuses, they all use nebulous wording and refer to possible future action. Management isn’t providing any substantial data, facts, or plans. When management makes announcements, look for things that are concrete. Look for facts, numbers, and definite plans.
Too often overly promotional management announces partnerships and cooperation agreements that amount to nothing more than good public relations. If a company is attempting to rebut a negative report, look for them to provide data that backs up its claims. If an analyst claims a company has a factory that isn’t producing any goods, management should offer proof that it is. The fact that the analyst never contacted management is irrelevant in discussing the status of the factor. Similarly, many companies announce share buyback plans or plans to pay a cash dividend in hopes of boosting their stock price or staving off short sellers. Plans are nice, but wait until the company actually buys back shares or you have the cold hard cash in your hand from the dividend before getting excited.
Finally, although Lewis Black is just a comedian, his quote applies to investors. If management can’t offer simple explanations for something, then it’s likely they aren’t telling the whole truth. Enron claimed its business model was a “black box” that couldn’t be understood. Want to avoid another Enron? Invest only in businesses you fully understand or where management gives simple, logical explanations of how the business operates. Avoid black boxes and overly promotional management teams.
SAIC Filings Matter (and Other Local Regulations Matter)
One of the most contentious