How To Avoid Investment Fads, Frauds And Failures

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During his recent interview with Tobias, Mark Simpson, author of Excellent Investing: How to Build a Winning Portfolio, and manager of Danger Capital, discussed How To Avoid Investment Fads, Frauds And Failures. Here’s an excerpt from the interview:

Tobias Carlisle:
Oh, yeah. It’s out of my hands. So I’ve already handed that over to the system, so I don’t have it. I don’t get to make that decision anymore, thank God. I’d hold it. That’s my instinct, it’s to hold it. In the optimism bias context, you talk about fads, frauds and failures. So let’s talk about, how do you avoid fads?

Mark Simpson:
This might be controversial, but I don’t think you should necessarily avoid fads. Fads can be very profitable on the way up. They can be quite hard to spot, but I think there’s a couple of clues. The first one is single product companies. So I think I used the example of Crocs.

Tobias Carlisle:
That’s what I was thinking of, they’re coming back.

Mark Simpson:
Yeah. They come back in and it’s like, you think-

Tobias Carlisle:
They were a knit at one stage. You could’ve got them as a knit.

Mark Simpson:
Oh, really?

Tobias Carlisle:
Yeah.

Mark Simpson:
But when you’ve got one product you are massively exposed to these trends and also your advertising isn’t as effective. Whereas if you take a luxury goods company, you advertise Burberry and they could sell shoes or they could sell ties, anything that fits that brand, can sell well and the advertising adds value. Whereas Crocs, it’s like you either want a pair of Crocs or you don’t. And for a long time people wanted them for a long time people don’t-

Tobias Carlisle:
We feel very strongly about them both ways. That’s right.

Mark Simpson:
Yeah. I picked that because people have an emotional reaction to what they like.

Tobias Carlisle:
I have been to the UK a few times. The last time I was there, Burberry had a problem where the chavs, there was like this… Just explain to everybody what a chav is and what the problem was.

Mark Simpson:
So I guess the classic definition of a chav would be yes, somebody who is from a relatively poor background who probably has money to spend on quality goods.

Tobias Carlisle:
Very delicately done, you’ve diffused that bomb very well.

Mark Simpson:
But they’re probably not as discerning or they don’t have the background that somebody who has always purchased luxury goods has. So it tends to be an insult really. It’s something used for somebody who wears a certain style of clothing. And this is the issue Burberry had was they had a very unique check pattern that defined their clothes and then people of this demographic started wearing it. So then people of their more classic demographic stopped wearing it, but I think because they weren’t a single product company, they were okay because they still had the brand, they just had to lose the check pattern on everything. It was the check pattern that stood as being… You can think maybe Canada Goose might be an example of a fad that has now maybe become too popular that now people love to hate it rather than actually love it. This represents people who are showy and have, however much it is $500 to spend on a winter jacket that they’re everywhere in the city. Sorry.

Tobias Carlisle:
I think they’re seven or 800. I’ve been short Canada Goose goes for a few quarters now and full disclosure, so I’m 100% in agreement.

Mark Simpson:
There’s the deep value investor who’s never going to spend $800 on a jacket.

Tobias Carlisle:
I can’t do it either. And I lived in California, so there’s no need, but I still see them around, which just makes no sense at all.

Mark Simpson:
Yeah. Which is because people are using them as a status symbol and once people turn against that status symbol, the fads quickly ends, in my opinion. I guess we’ll see whether your short is successful in that.

Benford’s Law

Tobias Carlisle:
It’s working, but I’m always nervous about the shorts, they can always blow up in your face. In the discussion on frauds, you talk about Benford’s law. Just one of my favorite ways of identifying something that are a bit weird and I think you could’ve applied it to the DNC primary over here. That doesn’t even concern me, but I looked at the results just eyeballing the results and I thought that’s a really weird distribution and I bet if I applied Benford’s law to that I would find that someone had filled those results. But what is it?

Mark Simpson:
Oh, really. Yeah, so Benford’s law is this chap called Benford found that any series of numbers produced by a natural process tend to follow a certain distribution. So the number one is the most common digit followed by two going down through the numerals. So if you do a science experiment or you produce a set of accounts that are made up of lots of small accounting entries over the year, the numbers that are produced should follow Benford’s law so one should be the most common number and going down. So if you’ve made up a set of accounts, so this is not your earnings manipulation, but guys who just completely made up the numbers and people tend to think that certain numbers are more random than others, like three and a seven. And I know they’re not, but I still have this feeling that-

Tobias Carlisle:
Well, it’s because they’re not numbers. So even numbers don’t feel random and they’re not the one or the 10, which are both the ends of the distribution. It’s not five because that’s the middle so that only leaves you with threes and sevens.

Mark Simpson:
Yeah. And it’s like if you ask somebody to pick a random number between 100, people pick 37 or 73 because they feel I’m left right.

Tobias Carlisle:
It’s the most random number.

Mark Simpson:
They’re the most random numbers because they’re prime numbers.

Tobias Carlisle:
Do you think that they know that they’re prime, off the top of their head?

Mark Simpson:
Well, yeah. Maybe they just feel it, but there’s definitely that aspect. And the other aspect that people don’t like when making up accounts is they don’t like to put a zero on the end. Feels too precise. It feels like if you made exact numbers, you are trying to show that you’ve made the exact numbers so therefore people are going to say, “Well, you just made up that number.” So they under-use the zero as a trailing digit. It’s a second level thinking thing that catches people out as well.

Tobias Carlisle:
And in terms of identifying failures, what do you recommend there?

Mark Simpson:
So for me it’s pretty much balance sheet strength. So all the evidence of this stuff is found on the balance sheet. So the classic one is just to look at the current ratio or the quick ratio. There’s a guy called Paul Allen who’s a accounting professor and wrote a book called Choose Stocks Wisely, again, a deep value guy. And he takes an adjusted current ratio. So he takes all the current assets apart from cash and says, “I’m going to take 0.8 of those.” He’s giving us fire sale or-

Tobias Carlisle:
It’s the grand discounted net current in asset value approach.

Mark Simpson:
Yeah, except he’s using it for just testing of balance sheet strength rather than yeah. His theory is you want a company that’s strongly capitalized in the short-term that they can survive the turnaround and the effect of… So I think that’s a classic one. You then go into the more metrics that people have produced. I think the Altman Z is the classic one and that’s been updated. I think Black-Scholes-Merton fame treated the equity as an option on the assets or something like that and he came up with a formula as well. And… like Olson and then Campbell… I’m going to get this wrong. Hillshire and… or something like that. I think produced the latest one and they all either have a threshold and the easiest thing is you get these from a data provider, whatever you use to screen your stocks or whatever, you use those. What did you use in quantitative value, was it Olson?

Tobias Carlisle:
We used a few. What we found was interesting at a universe level, excluding the 5% that are the worst on Olson’s, Altman and I think we might’ve used some earnings manipulation type measures as well. So we used to stress earnings manipulations, statistical fraud and I still do this because I do think this is a good approach. If you exclude those stocks from the universe, you get a couple of percent of better performance out of the entire universe.

Tobias Carlisle:
The funny thing is that if you’re already a value guy and you’re looking for these cash rich balance sheets and strong earnings, you don’t really find yourself excluding very many companies from that list because you’re already looking for those better quality things, but I still do it as a step just in case something slides through into there. And the other thing I always look for is just a divergence between the reported earnings and the cash flow. The accrual that builds over time is a pretty good indicator that there’s some shenanigans because you don’t really necessarily, you rarely find earnings manipulation or fraud in a company that’s going really well because they don’t need to do it. So all that stuff turns up in distress.

Mark Simpson:
Yeah. Interesting you say that though. The Beneish… There’s certain factors that yeah… So he splits into two. He looks at what type of companies are likely to be earnings manipulators and then he looks at, well what are the signs of earnings manipulation? So obviously the signs of the earnings manipulations are the increasing accruals, some of those other balance sheet entries, but the things that the type of companies actually tend to be the fast growing ones because and there’s an interesting theory on this from a guy called Dan Davies who wrote a book called Lying for Money, which is about the types of frauds you get.

Mark Simpson:
And his theory is if you’ve got a fraud, you’ve got almost two sets of books. You’ve got the real set of books and you’ve got the fake set of books and both have to grow. So you’ve got two things that are compounding so anything that grows unusually rapidly, you have to investigate. So it can be the distressed companies that have an incentive and obviously are going to miss banking covenants or declining gross margin and things like that are all I think declining gross margin is one of the Beniesh tests as well. Those things are in there, but interestingly, rapid growth is one of the signs.

Tobias Carlisle:
Yeah. That is interesting. That’s funny that John Hempton pointed this out to me a long time ago, that one of the things that you look for is an unusually large asset that just shouldn’t be there. So Parmalat which was the milk company that went under, they had $1 billion in cash. So they said in this bank, and the auditor sent the junior audit employee to the bank to get the letter. The bank said, “Yeah, they’ve got the billion dollars here,” but the bank was it on the fraud too, which just shows how hard it is to prove. The reason they asked was because they were missing some debt payments of why they have $1 billion here and you’re paying your debt over here.

Mark Simpson:
Yeah. That was a classic in one of the examples given in the book of a UK company called Globo, is that they claimed they had 100 million euros of cash and 50 million euros of debt and they were trying to raise U S dominated bond at 10% yield or something like that. And it was clear there was something going on there. Yeah.

Tobias Carlisle:
It’s funny as we’re talking about this, Musk has said on the last earnings call that they don’t need any capital and they’ve just raised 2 billion or they said they’re about to raise $2 billion in capital.

Mark Simpson:
Well, with the price, he’s stupid if he isn’t… Well, I’m going to be careful what I say here, but if you’re going to keep the game going, then you need capital and you’ve got to raise it when-

Tobias Carlisle:
They’re also potentially perfectly innocent excuses too, like when the stock price is high, I’m going to raise capital. If I was running a business, that’s what I’d be doing. When the stock price is low, I’m going to buy back stock.

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