A shareholder asks Warren Buffett and Charlie Munger on their experience in detecting financial fraud. Mr. Buffett says that he is skeptical with anyone who has an idea that is too good to be truth. In addition, Mr. Buffett was amazes how widespread the use of EBITDA, and he believes that EBITDA is one way to dress up financial statements.
Buffett & Munger: Detecting Financial Fraud And Trap Of Using EBITDA
I have two questions the first one I would like to direct to Mr. Munger pertaining to cash flow analysis. Given the practices of the numerous corporations of deliberately fabricating cash flow numbers which occurred in some of the telcos where they characterize like kind exchanges as the product sales. How do you ferret out this type of fraud. What do you recommend a shareholder and individual investor to do short of obtaining a degree in forensic accounting to uncover this type of fraud. And the second question is on a lighter note what books would either of you gentlemen recommend to shareholders that you read this year that you like.
Yeah I think you're asking for a lot. If you want some simple way of not being taken in by the frauds of the world. If you stop to think about it that enormously talented people. Deliberately go under fraud drift gradually into what because the culture carries them there. And the frauds get very sophisticated and they're very slickly done. I think it's part of the business of getting wisdom in life that you. Avoid getting taken by the frauds. And so I think you're asking a very good question. But I don't think there is any short answer. I think there are whole fields that you can just quit claim because it looks like there's too much fraud in it. And I think we do a lot of that don't we. Yeah. How many times have we been defrauded in the last 20 years. Well damn little that we can run. It's amazing how little. Yeah and I've always said that the guy who takes us is gonna have a modest little office modest demeanor and he'll carry around better Franklin's autobiography. I can hardly get.
The kind of people who could have brought us or are not going to be the kind of people who are defrauding everybody else.
Yeah. I mean it's a very good question it's tough to answer but I will tell you that we haven't and we won't get defrauded often. Now that may mean we pass up a whole lot of other opportunities too. But for example you raise the question about cash flow. I would say. The number of times we're going to buy into a company. Whether it's. Through stocks or through the entire company where people are talking about EBA dies is going to be about zero. I mean. We start out with if somebody talked about a ba da. You know. If we take all the people in the world to talk about EBA Don all the people in the world who haven't talked about EBA die.
There are more frauds in the first group and percentage wise by a substantial margin very substantial. I mean it is a you know it's just a start that isn't you know that. It is very interesting to me if you look at. Some enormously successful companies Wal-Mart, General Electric, Microsoft.
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I don't think that term has ever appeared in their annual reports. I mean they just so when people are talking about that sort of thing either they're trying to con you in some way or they con themselves to a great degree. I mean it's both. Yeah. Well that often happens. I mean if you set out to con somebody after why you kind yourself which is why some of the people on the Internet stocks you know stayed with them. It's. If somebody is if they think you're focusing on a neighbor dog they may arrange things so that that number looks bigger than it really is. It's bigger than it really is anyway. I mean the implication of that number is that it has great meaning. Do you take telecoms spending every dime that comes in. I mean in many cases and there isn't it isn't cash flow. I mean the cash is flowing out. But it you know you can look at the statement and there's billions of dollars supposedly and depreciation and so on. But there you know interest is an expense. Actually taxes are going to be expense. Anybody that tells you that making a lot of money before taxes that in terms of EBITDA is meaningful. You know that you get depreciation by laying out money ahead of time it's the worst kind of expense. We look for float where we get the money and then pay out later on. But depreciation occurs because you buy an asset first and then you get the deduction later on. It's it's the worst kind of expense there is. And. You start paying taxes when you actually make money. And when the depreciation runs out at some point. So it just amazes me how widespread that. The usage of evil has become. And I would say there have been people who have tried to dress up financial statements in a way to appeal to people who were impressed by such a number. Charlie and I have found actually that. Least to us. Many of the crooks look like crooks. I mean we have spotted it. We haven't shorted them but we we have spotted a lot of. Frauds over the years in public companies and years before. Know. That. The roof fell in and they usually are people. That tell you things that are too good to be true. For one thing I mean they they you know they tell you very mediocre businesses are wonderful businesses for one reason or another or they they just they just have a. Have a smell of Autumn you know and then in effect. And I wouldn't say that's true joy. Well sometimes it's amazingly obvious.
Maxwell of England. His nickname was The bouncing check.
And three weeks before he went under Solomon went under and all Columbine was aggressively seeking more business from him.
With both Warren and I on the board it shows how much influence outside directors often have.
Yeah. Wall Street is extending credit to a guy whose nickname is The bouncing Jack. You'd think if you're out of the satire people would say it was too extreme to be funny. We have read.
Mature outlines. It's a hobby keeping track of the max walls of the world and then the that they get.
There is a syndrome I mean that they give off a lot of the same same messages and I mean actually was a classic case but their time after time Wall Street is no filter against them. Wall Street loves them as long as they know as long as they're pushing out securities and commissions that are what Charlie and I could not have stopped Solomon from making a deal with Maxwell you know right to the last 30 seconds before he sunk you know under the ocean and we didn't stop first Normandy with Lou Simpson and Warren Buffett and Charlie Munger on the board. Yeah. First Normandy was a case of some guy that. Manufactured a record out in California. That he claimed was from owning a bunch of securities including Berkshire Hathaway. And. He was going to go. Public. And Solomon was courting him and the record wasn't you know it was total baloney. And I think they actually went public for a day or so and then the S.E.C. pulled it back.
Absolutely. They knew they had the offering and then they canceled it before the money changed hands. But it was a very embarrassing episode. And when we remonstrance it against this obvious insanity they told us the underwriting committee had approved it.
I don't think they changed either writing committees either.