Home Value Investing Detecting Fraud By Scrutinizing the “How” of Management Disclosures

Detecting Fraud By Scrutinizing the “How” of Management Disclosures

“Attained wisdom” — these words were emblazoned boldly in the Annual Report of one of Singapore’s most valuable listed tech companies at one time. Its stock price subsequently plunged more than 60% and the stock was delisted in November 2008.

Detecting Fraud By Scrutinizing the “How” of Management Disclosures

“I can almost bend steel with my mind. I can bend anything if I try hard enough”, Martha Stewart proclaimed when interviewed by Oprah Winfrey in August 2000. Martha Stewart, her namesake company, had a market cap of $1.5 billion then. A year plus later, on December 2001, she received inside information about ImClone Systems, and she sold her ImClone shares. In March 2004, she was found guilty of insider trading. Since her remark in August 2000, the value of Martha Stewart had plunged more than 80% to the current $270 million, while the S&P 500 is nearly flat during the same period.

The disclosure of words — the level of disclosure (how much you say), its tone (what do you mean), and its transparency (how you say it) — can reveal whether an entrepreneur or manager is a Bamboo Innovator. The bamboo is regarded by centuries of moral philosophers as a complete pattern for correct human behavior. It stood for constancy, because it remains evergreen throughout the year; integrity, because when split, its parts are straight and even; purity, because its heart is always empty and immaculate; rectitude, since in the wildest of storm, it bends without breaking and stands up again. The accounting of words that stood for constancy, integrity and rectitude can be an additional helpful tool for value investors to ferret out the resilient compounders — the Bamboo Innovators.

The Importance of Linguistics

Linguistic communication is an important source of qualitative information with valuation relevance about the firm. While language use is regulated in contexts such as the U.S. Food and Drug Administration (FDA) for drugs, managers are accorded ample flexibility in their communication with investors. Opportunities are thus presented for value investors to analyze not only the text of the Annual Report, Management Discussion & Analysis (MD&A) sections and IPO prospectuses, but also press releases, conference calls, and management interviews. Investors may scrutinize the content for truthful revelation or opportunistic structuring of language in these situations by managers intent on hiding adverse information from investors.

By: beyondproxy