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 issues in the Chinese RTO space has been the financial information that companies in China must file with the State Administration for Industry and Commerce (SAIC). Bulls argued that these filings do not matter, while Bears argued that they did and gave a true picture of the company’s financial condition. The truth is and always has been that the SAIC filings matter a great deal. What legitimate management team would risk having its business license revoked by not following regulations?
As we mentioned above, it is important to consult independent sources when doing research. Many bulls have used quotes by Benjamin Wei (or Wey) of New York Global Group. However, he has been involved with many Chinese small caps that have had fatal accounting issues, and in no way can he be considered an independent expert. Instead, let’s look at what several independent sources say about SAIC filings.
First, look at the SAIC itself. They have published a list of requirements, in English, for foreign investor enterprises. The list is available here: http://126.96.36.199/ae/ae_1.html. As you can read, audited financial statements play an important role and the penalties for noncompliance are severe, including a loss of business license(s).
But perhaps the SAIC is lying just to frighten businesses into registering or some other nonsense. Let’s look at another truly independent source. There is a book on Chinese law published by the ABA called China Law Deskbook by James M. Zimmerman, Esq. A 2005 edition is available on Amazon.com and a free preview of the 2010 edition is available on Google Books. Again, in the book, the author confirms that a SAIC filing must be accurate and be prepared by Chinese CPAs.
Finally, we can logically show that SAIC filings should be accurate by using a 2×2 payoff matrix chart. Management has two choices regarding two options: (1) they can lie to the SAIC or tell the truth; or (2) they can lie to the SEC or tell the truth. The payoff matrix below shows the result of each choice.
|Lie to SAIC||Lie to SEC|
|Upside||None. Publicly available SEC filings would show true business to all competitors and Chinese government.||Able to steal millions of dollars from U.S. based investors.|
|Downside||Fines and/or loss of business license. Short seller attacks.||None. The SEC has no enforcement power over Chinese individuals.|
Utilizing a simple payoff matrix, it’s easy to see that management gains nothing by lying to the SAIC and also has absolutely nothing to lose by lying to the SEC.
While the issue of SAIC filings is specific to China, there is a larger lesson for all investors. Local country regulations matter and researching public filings that companies must make in their home countries can provide a powerful way to verify if management is trustworthy.
Undoubtedly, there are local rules and regulations that are ignored as part of the business culture in certain countries, so investors must ask themselves whether or not they want to be partners with a management that is willing to lie. The sophisticated investors in Bernie Madoff’s scam believed that Madoff generated his returns by front running his brokerage clients. They were all too happy to join him in taking advantage of others. Only later did they discover they were the real patsies and that if a person was willing to lie about one thing for his own benefit there wasn’t a limit to how far the deception could go.
Investors would be wise to insist on investing only in companies where management follows all local rules and regulations, significant or not.
Short Sellers Aren’t Evil
Invariably during or in the aftermath of a scam, scandal, or fraud, management and investors always are quick to blame their predicament on some sort of evil short-selling cabal (second on the list is the equally ludicrous “lack of liquidity” excuse). But short sellers are very rarely to blame. In fact, I am unaware of the demise of any company due to a short-selling conspiracy.
The closest thing may be the saga of Fairfax Financial. Dan Loeb’s Third Point, Jim Chanos’ Kynikos Associates, and Steven Cohen’s S.A.C. Capital, and others had shorted Fairfax Financial and began a campaign to publicly discredit Fairfax’s CEO Prem Watsa and “assist” the media and financial analysts in releasing negative reports about the company. Short sellers may have partially been vindicated when the company took a write down in 2006, but documents released as part of a lawsuit filed by Fairfax certainly show some shocking behavior by the short sellers. The truth of the situation likely won’t be known for some time as the lawsuit is ongoing. Even if the lawsuit is true and there was some sort of evil short conspiracy, it’s important to remember one thing.
Unless a public company depends on continued access to the capital markets for its survival, there is little if anything short sellers can do to permanently impair the value of the company.
Ben Graham famously said that in the short term the market is a voting machine but in the long term it is a weighing machine. Accusations of fraud certainly have a short-term vote but they weigh nothing. Only the company’s true cash flow has weight; if the company is committing fraud, eventually the earnings power and cash flow of the business will be revealed to be less than what was reported. If it wasn’t fraudulent then the cash flow will be revealed to be genuine and the price will reflect that over the long term. Again, look at Fairfax Financial. While the stock fell in the short term because of the short sellers’ allegations, the truth was eventually revealed and the stock price recovered.
There is almost never any need for investors to get worked up over some mysterious evil short selling cabal. If you’re right and the facts back you up, then in time your investment will be rewarded. It’s also important to keep in mind in matters of fraud and accounting irregularities more often than not it’s the short sellers who are ultimately proven correct.
I hope these 10 lessons can help all investors become more diligent and avoid the next CCME.
Did you do your due diligence in reading this article? How many of you noticed there are only 9 lessons between the two parts, or did you just believe that there were 10 because that’s what the title said or I said? This is lesson 10. Always read everything carefully, twice. The only person you can trust is you; everyone else is guilty until proven innocent.