Value Investing

GLOBO Plc – A Few Lessons From A Company “Fraud”

A Few Lessons From A Company “Fraud” – What I Have Learned From The Case Of GLOBO PLC by Anton F. Balint

The recent storm caused by the AIM listed GLOBO PLC (LON:GBO), the mobility enterprise developer and provider which is investigated for market abuse, accounts falsification and insider dealing does not come without important lessons for all its shareholders and other market participants that look for exciting opportunities. The company is currently under investigation by the Financial Conduct Authority, the Serious Fraud Office and the City of London Police, according to Investors Chronicle (30 October – 5 November 2015 Issue).

While it is true that investing in the stock market naturally involves unknown risks, no one that allocates his or her capital in a business should worry that the financial fundamentals of that business are not trustworthy. The reported accounts should serve as the most trustworthy source to conduct the company valuation. However, the past cannot be changed – we made the mistake of investing in Globo Plc. What can we do now? We can learn from our mistake. This article looks at the ‘symptoms’ that set the alarm across the capital markets that Globo Plc is a fraudulent company. The signs are presented in an objective manner and are not tailored after Globo’s situation because they can serve as the basis for uncovering fraud in other industries, markets or jurisdictions.

However, before carving out the red flags, it is important to take a moment and meditate upon what some value investors, including myself, have done wrong.

GLOBO

(My) Mistakes

Firstly, the company was presenting itself as a strong player in an industry (the mobile software development market) which I still believe that it will impact on many other business sectors – mobile payments for example are becoming an increasing habit of many consumers. Therefore, I allowed myself to account for its goodwill more than I usually do (20% of the reported value)-in this case I allowed for 50%. This resulted in a higher price being justified.

Secondly, I chose to ignore the consumer reviews that were overwhelmingly negative. Why? Because I focused too much on building the financial ratios profile and compare it with its peers. Thirdly, I did not do enough research into why it was short-sold: in other words, I did not gather enough information that contradicts my position in order to have an informed position.

Finally, I did not stay into my circle of competence: even if the company’s product and services were not hard to understand its business model seemed a bit twisted and unclear. However, I still decided to make ‘an exception’, thinking that this time is different. If you take just one thing from this article, remember what Sir John Templeton said: ‘The four most expensive words in the English language are, “This time it’s different”’.

The signs

Sign 1: The customer base – the source of revenue

Source and Transparency of Revenue: It is important that the company’s main source of revenue matches its target markets. Moreover, it is important that, if the business makes money in more than one jurisdiction, there is a clear breakdown of how much revenue and from what service or product the money were made in each region. The financial reports must show consistency in breaking down the sources of revenue: if the company has been listed on the stock exchange for 10 years, all 10 years of reports ought to be checked for consistent and transparent accounting of revenue sources. Finally, looking at the relationship between the suppliers, the company and its clients will shed light on its business model that might or might not show the existence of shell companies. Make sure that your research is thorough: look for evidence that contradicts your initial position on the company.

Quality of product or service provided: Nowadays, the internet allows us to quickly read hundreds of customer reviews for a specific product or service. Moreover, if it is a software company, investors are encouraged to check how many times the software packages were downloaded and on which devices (you don’t want a software that is made exclusively for a hardware that is likely to fall behind technological development).

Also, calling the company’s customer support and asking for directions on how to use its products will reveal how responsive and knowledgeable they are in answering client inquiries. Additionally, checking the competition’s services or products will help for a better comparison of quality and price of whatever your target company has to offer.

On an equally important note, analyse the product range: does the company provide something that big brands already bring to the market? For example, Globo’s mobility enterprise software was definitely not the only one: the likes of Microsoft and IBM were already established names within the market. Consequently, what makes the product different and does this quality that makes it different can be sustained with a low capital investment?

Sign 2: The management’s approach towards discussing the business

The candour of its management: If you have doubts about anything regarding a business, its senior management should be more than willing to at least bring some details to your mind. The management runs the company for the shareholders, not the other way around- shareholders are the business owners. Consequently, the management should be willing to answer questions of fundamental importance about the company.

Intra-company sales: Should the business model involve intra-company dealing, the management must disclose it clearly and in a very structured manner – names like Enron and Hanergy come to mind when investors hear about intra-company activity.

Checking the reliability of auditors: The company has to be audited by well-established auditors. This is not to suggest that big firms with a strong brand name for their auditing services cannot make mistakes – we look here for auditors that are not so small or new that can be influenced by corporate pressures, i.e. we look for auditors that have the capacity to be as independent as possible and in case of mismanagement they are not afraid to say because that might cost them a client.

Sign 3: Accountancy issues

Cash Conversion Cycle: Are trade receivables increase dramatically year on year? If yes then one must compare that figure with current receivables and if there is a wide discrepancy between the numbers due diligence work is required to uncover whether revenue is recognized but not invoiced and/or if there is a consistent increase in current receivables the figure must be converted into days of sales. Then the investor must ask himself/herself why the company has problems to convert revenue into cash?

The relationship between free cash flow and receivables: A company that grows its earnings and receivables but has negative cash flow for most of its business life it is either using dodgy accounting practices or it is a bad business that should be liquidated. Why? Because it means that little or no profit is being collected: bottom line earnings are not the ones that pay the liabilities, cash collected from these earnings is the source of liability repayment.

Other reasons for negative cash flow but increased earnings can be the capitalization of intangibles, lack of real customers or bad quality of product/service.

Capital structure ‘shenanigans’: A few eyebrow raising moves include issuing a high yield bond when there is cash in the bank (at least according to what the company reports); an increase in capital expenditure satisfied by the issuance of more shares; and not passing the credit worthiness assessment conducted by possible creditors (banks, building societies etc.). Similar considerations should be: what exactly is covered in the product development cost? Why are the clients not paying the business (this being suggested by higher and higher receivables)? And if there is a large percentage of revenue derived from intangible assets, can such assets be traced easily?

Sign 4: The presence of satellite companies

Vague contact details, generic websites or unclear addresses: Shell or satellite companies have the following common features: they are mostly located in non-transparent and hard to reach jurisdictions with unclear laws, they show little or no evidence of business activity in general (or in connection with the investment opportunity in question), their addresses are in residential areas where many other ‘companies’ are registered in the same building or even on the same address, their websites are generic and vague with few contact details, they have bad phone connection and usually don’t respond to emails and might have logos similar with the fraudulent company.

In the end…

The article tried to offer an overview of the symptoms Globo showed investors that a fraudulent company is illustrating. However, it should be obvious that the list is not exhaustive – feel free to add more to it from your own personal experience or from the literature that you pursue.

I hope the article will help, at least on a basic level, some investors that don’t have the time to read through the reports of the two hedge funds and the articles presented by the financial media.

Sources:

Ennismore Fund Management

Quintessential Capital Management

Financial Times Alpha Vile

The Motley Fool

Globo PLC’s statements