In this episode of The Acquirer’s Podcast Tobias chats with Stephen Clapham, the founder of Behind The Balance Sheet, which provides research, forensic accounting training courses, and consultancy for professional analysts and private investors. During the interview Stephen provided some great insights into:
- Some Quick Ways To Spot Company Frauds
- Beware Companies With Complicated Accounting Policies
- Most Companies Will Use This Latest Turmoil To Re-Base Their Earnings
- NIPA Margins vs S&P 500 Corporate Earnings
- Non-Gap Earnings – Three Card Monte
- Earnings Manipulation Is Closely Correlated To Management Incentives
- The Huge Fraud In A Coffee And Cake Firm
- Working On The Buy Side With Tiger Cub, Martin Hughes
- This Is Not Carnage Like 1987!
You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:
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Full Transcript
Stephen Clapham:
Cool. I’m ready.
Tobias Carlisle:
Hi. I’m Tobias Carlisle. This is the Acquirers Podcast. Today I’m speaking to Stephen Clapham of Behind the Balance Sheet. Remember financial statements? We’re going to talk about those right after this.
Speaker 3:
Tobias Carlisle is the founder and principle of Acquirers Funds. For regulatory reasons, he will not discuss any of the Acquirers funds on this podcast. All the feelings expressed by podcast participants are solely their own and do not reflect the opinions of Acquirers Fund or affiliates. For more information, visit acquirersfunds.com.
Tobias Carlisle:
Hi, Stephen. How are you?
Stephen Clapham:
I’m good, Tobias. How are you doing?
Tobias Carlisle:
Very well, thank you. I watched your Real Vision interview where you talked about the dark arts of manipulating financial statements and your history as an investor in hedge funds and now running Behind the Balance Sheet. Let’s just talk very quickly. Can you give folks at home a background and how you got to run Behind the Balance Sheet?
This Is Not Carnage Like 1987!
Stephen Clapham:
Sure thing. Well, I’ve been an equity analyst for an amazing long time. I came into the stock market about the time the big bang in the U.K. when everything was deregulated and-
Tobias Carlisle:
What vintage is that?
Stephen Clapham:
Oh, I’m embarrassed about how old I am, so I like to say in the mid eighties-
Tobias Carlisle:
I just want to see which crashes you’ve seen. That’s what I’m trying to figure out.
Stephen Clapham:
I’ve seen them all, bar 1929. I didn’t live through … as a practitioner, I didn’t live through ’73 so I missed that one. I lived through 1987 crash, and I hadn’t been there very long and I was telling this story the other day, actually. We were doing in interview on Radio 4 and the BBC here in London, and they said to me … this was three weeks ago, so it was actually right at the beginning of March. It was probably the second of March before the stock market had started to crack, and I came on to say, “Look, fasten your seatbelts. It’s going to be awful.”
Stephen Clapham:
The following week, I was asked back and the markets had started to wobble. Somebody said, “Well, what are you going to do about the carnage in the stock market?” I said, “Carnage? Carnage? This is not carnage. 1987 was carnage,” because 1987, you came in in the morning, you didn’t know why the stock market was crashing and every day was horrible. Now, not as bad as we’ve seen recently, because these markets have been just horrendous, but we know why, right? You can plot what’s happening. You understand what’s happening, and many stocks haven’t moved that much.
Stephen Clapham:
I was looking recently at a couple of stocks that we’ll get into later, but anyway, so I saw the 1987 crash. I worked as a sell-side analyst for many years. I always did well in my sector. I did the transport sector mainly. Then in 2005, one of my clients asked me to go and join. I’d ended up … I was a small boutique brokerage firm and I just had a small club of clients, so I had some of the traditional names you would think of like Fidelity, where analysts are highly incentivized to make money, and then I had a group of hedge funds and basically they were my main client base. I did very detailed, very in-depth research and some of the hedge funds, you always think of the hedge funds as being fast money. Some of the hedge funds are fast money, but some of the hedge funds are very, very detailed oriented, very, very long term, and they want sell-side analysts to give them the real dig deep, go down into the weeds sort of stuff.
Stephen Clapham:
I used to have one client, which actually was taken over by SAC, and they always used to call me up and they used to say, “Well, we’ve got this airline reporting the quarterly results next week. What do you think?” And I always used to say, “You know what? I don’t know why you’re calling me because I don’t have a clue about the next quarter’s results. I can give you an informed guess,” but honestly it’s a guess. I don’t know that much. It’s extraordinarily difficult to forecast one quarter’s numbers. It’s hard enough to forecast a year, but when you get down to quarters, it’s even more difficult. You look at an airline, it’s really hard.
Working On The Buy Side With Tiger Cub, Martin Hughes
Stephen Clapham:
One of my clients, Martin Hughes at Toscafund who is one of the tiger cubs, so Martin started out in the hedge fund world by working for Julian Robertson, and Martin called me up and said, “Come and see me,” and he offered me a job. Of course I took it, and it was the most amazing thing because I thought to myself, “What an idiot you’ve been sitting on the sell-side all this time. This is much more fun, for two reasons. First of all, you get all the sell-side input, and second of all, you’re investing real money.” So it’s much, much more interesting because I was no longer trapped in a narrow sector. Martin did global investing and he brought me in to do the non-financials piece. He was a financials analyst, a bank specialist really, and I did the non-financial area.
Stephen Clapham:
I carried on working for hedge funds until relatively recently. I ended up … I was at a smaller fund I joined in 2016 to try and help them grow the business and it was disastrous. The first day I arrived was the first working in 2016, and the markets were down 3%. We were long going in, and honestly, we never recovered from that. In about April 2017, the founder called me in and he said, “Look, Steve, I’m going to give it until December, but I’m not sure I’m going to continue.” Of course, we had some redemptions. The fund wasn’t going well, and the economics didn’t stack up. I thought, “This is going to close. I better go find another job.”
Stephen Clapham:
I applied for … I think it was 47 jobs. Do you know how many interviews I got?
Tobias Carlisle:
I do, because of what you-
Stephen Clapham:
Zero. Oh, sorry, I told this story and ruined it. I apologize-
Tobias Carlisle:
No, no. I want to hear it.
Stephen Clapham:
It’s extraordinary. In the United States, people value experience. I can remember meeting multiple analysts who were in their sixties. In London, people don’t want you if you’re over fifty. It is a young man’s game, and I just couldn’t get any traction. I thought, “What am I going to do, because I reckon I’m a pretty good analyst, but I’m incompetent at anything in the real world.” I’m good at one thing. I struggled with it. If I can’t do a job as an analyst, what am I going to do?
Stephen Clapham:
Somebody came up with the idea of my setting up a training business and that was how I started doing training and about 18 months ago, I was asked by Stuart Investors, which is a $40 billion, $50 billion AUN specialist in emerging markets and they do some global funds as well. They’re quite an unusual institution because they don’t use sell-side research. What they do is if they are interested in a subject, they put a request for tender and they award the job to the person that gives them the best tender. They asked me if I would do a forensic accounting course for them, and I said sure. I set up a training business, so that’s exactly what I want to do.
Stephen Clapham:
I did it for them and I did it for one of my other clients and I thought, “Well, maybe other people will be interested,” and so I wrote a couple blogs about how we were going to see a multiplicity of frauds. I likened this period, and this was back in the third, fourth quarter of 2018. I likened this to the late 1990s, and I think there’s lots and lots of similarities. I said, “Look, what happened in the late 1990s was people started making up the numbers. It was eyeballs. Now it’s total addressable market.” I saw this use of non-gap numbers. “Don’t look at the real numbers. Here’s the fictional ones I’ve made up.”
Stephen Clapham:
I started writing these blogs and I was very lucky, and you always need luck in this business, don’t you? If you’re an investor, you need to be lucky.
Tobias Carlisle:
Indeed.
The Huge Fraud In A Coffee And Cake Firm
Stephen Clapham:
I was lucky. Many people were unlucky, because there was a company called Patisserie Valerie had a fraud. Patisserie Valerie is a chain of coffee shops and it was run … executive chairman was a very well known investor in the U.K. who’d been extraordinarily successful with other ventures. He’s a big private equity firm. He lost, I don’t know, £150 million. It was … last week it was a couple hundred million dollars. This week it’s a $170 million. He lost a huge amount of money in this fraud, and it was most extraordinary fraud because it was obvious. The numbers were obviously made up, because here was a very small cap stock selling … and it wasn’t just a coffee shop, it was a cake shop, and it was making higher margins than Starbucks. It takes you about two minutes to look at that and say, “That is obviously wrong.”
Tobias Carlisle:
Why is it wrong? Why is that wrong?
Stephen Clapham:
So very simple reason. Coffee is one of the highest margin products you sell, because what’s in a cup of coffee? You’ve got some coffee beans … look, coffee beans are not cheap, but coffee, you’re paying $5 for a takeaway coffee, right? You’ve got coffee beans, water, electricity, and a little bit of labor. It’s one of the highest gross margin products you can get. Cakes … you just need to look at the cakes. These cakes are incredibly elaborate, filled with cream, fancy piping. They go off … people consume them on the premises, so you need a waitress, you need a tale.
Stephen Clapham:
It’s not possible that a tiny business like Patisserie Valerie could make higher margins than a business like Starbucks. It’s just obvious. It was making much higher margins than any of its U.K. peers.
Tobias Carlisle:
So how were they misrepresenting that? What were the mechanics of what they were doing? Just lying.
Stephen Clapham:
They were making … the numbers were completely fabricated. The finance director was actually literally making the numbers up. It was a most extraordinary case. What was particularly extraordinary was that people assumed that the founder was a very successful businessman that he would be on top of all this. It’s still a mystery to me how he didn’t spot it. I mean, I’m sure he wasn’t complicit because he even injected money to keep the thing going, and then when it finally closed, he paid the staff’s wages for the last month out of his own pocket.
Tobias Carlisle:
Right. That’s classy.
Stephen Clapham:
I mean, really, yeah. A nice gesture. I mean, there’s no question he was shocked about it, because I saw him the week that it had bone bust, and his son is at my son’s school. The two kids are at the same school and I bumped into him at the school gates and I said to him I was terribly sorry and well done you for paying the staff’s salary and he looked at me and he couldn’t speak. He couldn’t get the words out of his mouth. It was a very odd case, because the numbers were totally made up and we’ll find out because prosecutions will happen to resolve this.
Some Quick Ways To Spot Company Frauds
Tobias Carlisle:
When you’re examining companies … so you’re a detail analyst. You invest both long and short. When you are looking at them, what are you looking at to … what are some of the quick ways that folks can identify some of these frauds or manipulations that are going on? What are you looking for?
Stephen Clapham:
There are some very simple things you can do. When I started doing the research for the forensic accounting course, I went to the British Library which has got every book in existence except Joel Greenblat’s … Seth Klarman’s, the one that you can’t get. It’s got every book in existence, and I started reading loads of specialist books on this subject, and then I started examining past frauds, because I thought, “The best way of working out how people do it is look at the ones that have been uncovered.”
Stephen Clapham:
The one thing that I found, and I think it was every single case, the margins were higher than the peer group. The reason for that is very simple. It’s much easier to fabricate the profits than it is to fabricate the revenues. Now, the frauds almost always also fabricate the revenues, but it’s harder to do that and there are more tell-tale signals, so they always, always fabricate the margins. They always boost the margins by more than they actually are.
Stephen Clapham:
Interestingly, paying dividends usually is a good signal and there’s only one case-
Tobias Carlisle:
A good signal for fraud or a good signal suggesting that it’s a healthy company?
Stephen Clapham:
It’s usually a good signal that it’s a healthy company, but I have found a couple of frauds where the founder was committing the fraud and the way he extracted the money was by paying a huge dividend. So dividends aren’t a consistently reliable indicator.
Stephen Clapham:
But the first thing I look at is always the margins versus the peer group. The Patisserie Valerie example is a classic illustration of that. Look at the margins and look at what the peers are making and if the margins look odd, the chances are there is something odd, right? So that’s the first thing that I look at and that is a very, very simple guide. You can do that in seconds. Obviously, I’m sort of a sophisticated investor. I’ve got professional style tools that enable me to do that just off a system and if you’re a professional investor, Bloomberg will give you that in a nanosecond. If you’re a private investor, it’s more difficult, it takes a little bit more time, but it doesn’t take you a lot of time to do that. You can do it very, very quickly.
Tobias Carlisle:
One of the funny things is that’s something that Buffett-style investors look for, higher margins, because that indicates that’s a stronger business. So that’s something you have to be particularly careful of, if you’re that style of investor.
Stephen Clapham:
Yeah, but I’m not saying that every company that’s got high margins or higher margins than its peers is a fraud. Of course not.
Tobias Carlisle:
Just puts you on notice.
Stephen Clapham:
I think if you’re … so it’s interesting, this idea about quality. Before I came on this, I was actually just recording some content for one of my courses and it’s about how do you find a high quality business? And of course, high margins are an indicator that you’ve got a good business, if it’s not fraudulent, but I tend to look at returns more than margins. If I’m looking for quality, my first screen is a high return. If you’re committing fraud, you, generally speaking, will be fabricating some of your revenues and by fabricating some revenues, on the other side of that you’ll create a fictitious asset. Generally speaking, frauds will have high returns but they won’t … excuse me. Will have high margins, but they won’t necessarily have high returns.
Stephen Clapham:
So if you start that exploration on the returns side, then companies that have high returns will generally be high quality and by doing that, you’ll end up excluding the frauds because they won’t be making as high returns. But yeah, you’re right. Some high quality businesses have high margins, but the distinguishing characteristic will be they will also have high returns and a fraudulent company, company that’s making the numbers up, won’t have.
Stephen Clapham:
So the second thing that I look at is working capital ratios. This is slightly technical. I think some private investors, some retail investors, find this sort of a challenging thing but it’s pretty simple. I mean, I tend to do it in quite a sophisticated way because if you’re cheating, then you’ll probably be quite subtle about it and it won’t be as obvious. If you look at the trade receivables to revenue, and the inventory to revenue, if those numbers are high growing, or high relative to peers, it’s usually an indicator of trouble. It may not be an indicator of fraud, but guess what? If your customers aren’t paying you, that is not good news, right? I mean, obviously, we’re doing this in the middle of the coronavirus epidemic and nobody’s paying anyone. In normal circumstances, if your customers aren’t paying you, there’s something wrong.
Stephen Clapham:
If you’re in a good relationship with your customers, they’ll pay you on time. So if your debtor days are drifting up, it’s either because your customers are unhappy or because there’s something questionable about your revenue or your customers maybe are in trouble. Maybe your customers are having financial trouble. Any of those three reasons isn’t good.
Tobias Carlisle:
Is that a revenue recognition type trick, like they’re trying to get the invoice out before the end of the quarter knowing that it’ll never be paid? They’re just padding it out and then the client just comes back and says, “This is all fictitious and we’re not going to pay any portion of that, or some small portion of it?”
Stephen Clapham:
Well, that’s exactly right. What you usually see is they’ll fabricate, or they’ll send an invoice out early and then the debtor days will go up. So they send the invoice out, the goods aren’t actually dispatched, or they just managed to dispatch them at the end of the quarter. Typically that’s what happens and the debtor days go up.
Stephen Clapham:
The other thing to watch for, and it’s just subtlety here, if you’ve got a crude income in the working capital, that is where you’ve not actually sent the invoice out but you’ve accrued the revenue. When you’ve got that and that is increasing, that’s an even bigger danger signal. That’s an even bigger warning sign because that tells you that management are making the numbers up and they’re accelerating the revenue. If you’ve got an acceleration of revenue, you’re either … you could be fabricating or you can just be pulling the revenues forward because you need to make your numbers for this quarter.
Stephen Clapham:
I think we’ve seen a huge amount of this in recent years because the problem is that executives are incentivized to make their targets and they’ve got huge amounts of money at stake. And you know that Charlie Munger phrase, show me the incentive, I’ll show you the outcome. Well, if you incentivize people with tens of millions of dollars of share options, would you be surprised if they’re a little bit aggressive in their revenue [inaudible 00:21:19]? Of course they’re going to be. There’s ten million reasons why they’re going to be, and this is the problem. What we’re going to see now in the aftermath of the virus is you’re going to see a whole bunch of companies where their numbers are going to be reset because now they’ve got the opportunity to say, “Oh, I know what we’ll do. All this padding that we’ve been having, what we’re going to do is we’re going to take that out,” and that’s exactly what we’re going to see.
Stephen Clapham:
The other thing that I look at on the working capital side is inventory. Inventory days are a really, really useful signal because often what happens is the sales look great, the profits look great, but the inventory starts to build up. The most classic example of this was Apple’s last profitable quarter, which was in June 1985. The profit numbers look brilliant, but the inventory, instead of going up in the same relationship to sales, the inventory had catapulted. What had happened, they’d been selling brilliantly and then the sales stopped. The next quarter, they made their first loss.
Stephen Clapham:
Watching inventory is really, really, really, really useful sign because if the inventory builds, it says your customers don’t want your product.
Tobias Carlisle:
Right. You said there’s a third way that you identify fraud as well, and that’s you’re looking at the cash flow relative to the earnings?
Stephen Clapham:
Yeah. I mean, if you’re generating cash your numbers aren’t made up unless you fabricated the cash. In the case of Patisserie Valerie, actually they even fabricated the cash and the finance director had managed to achieve two loans from two different banks which weren’t on the balance sheet.
Tobias Carlisle:
Oh, they just weren’t recorded.
Stephen Clapham:
Which weren’t recorded. In a way, I’ve got sadly grudging admiration for him because he managed to get a £10 million loan from HSBC, and when I did my first presentation on Patisserie Valerie, I explained to the audience … I did this investor conference in London. There were probably 300 people in the audience and I asked the people who owned Patisserie Valerie to put their hand up and there was like 10% of … more put their hands up, which means that 20% owned this stuff. Somebody asked me the question, “How did he manage to get this loan from HSBC?” I said, “Well, it’s complete mystery to me,” because at the time, I was the director of a U.K. subsidiary of a Hong Kong business and we had a bank account with HSBC in Hong Kong and we needed to open a U.K. bank account and HSBC in the U.K., their money laundering rules are so strict that we couldn’t open the account. It was taking us months. So this guy, obviously he was skilled.
Stephen Clapham:
The amazing thing about that was HSBC has lent this guy £10 million and the loan wasn’t in the balance sheet. What were they doing? You would assume if you were a bank and you lent money to a company, you assume that they’d open the report in accounts and check that the loan is there. You’d think that would be one of the first things that they would do. Who knows.
Tobias Carlisle:
How did the private equity go? I missed that.
Stephen Clapham:
Well, I don’t know.
Tobias Carlisle:
That’s pretty material.
Stephen Clapham:
Well, I think what happened was that when the finance director had taken the loan out, he’d fabricated the other signatures because obviously you need more than one signature. So I imagine that he must have fabricated the other signature.
Tobias Carlisle:
So the directors were just totally unaware that this had occurred at all. He just didn’t, at any stage, make it clear to the board that they’d gone and got a $10 million loan.
Stephen Clapham:
Well, apparently … I mean, this is what we have to believe, right, because that’s the only explanation that makes any sense. I mean, even that barely makes sense. With the exception of companies … I was going to say it’s very unusual. It’s not that unusual for companies to fabricate their cash balances. You see it often in Asia. There’s lot of stories about the Chinese, the back door flotations in the United States where they fabricated the cash and they colluded with the local bank manager. So they paid the local bank manager to lie and do that sort of thing. Honestly, it doesn’t matter how good an analyst you are. If they’re doing that sort of thing, it’s extremely difficult to spot. If the cash in the balance sheet isn’t accurate, you’ll struggle.
Stephen Clapham:
Generally speaking, for the vast majority of companies, even the vast majority of frauds find it to difficult to fabricate the cash. So if you look at the cash generation and you look at the cash generation relative to the earnings, that’s a super guide to making sure that you’ve got a proper business, and it doesn’t matter … I’m talking about frauds, but this is equally a measure of good companies because companies are going to make you money as an investor, companies that generate lots of cash, and if they don’t generate lots of cash you’ve got to understand why.
Stephen Clapham:
It fascinates me how few people understand the cash flow statement.
Tobias Carlisle:
I couldn’t agree more. Are you familiar with the Parmalat fraud at all?
Stephen Clapham:
Only in a very scant detail. I haven’t really studied it. It was another one where there was a lot of fabrication and obfuscation going on.
Tobias Carlisle:
They just fabricated some money in a bank account and the bank was complicit in it, is my understanding.
Stephen Clapham:
Yeah, I know what you’re saying.
NIPA Margins vs S&P 500 Corporate Earnings
Tobias Carlisle:
Let’s talk about NIPA margins versus corporate earnings, because I had this argument quite a lot about five years ago or so, and I was just interested to hear you raise it on your interview. So could you … what are the difference between the two and what do you think it indicates?
Stephen Clapham:
What happened in the 1990s was exactly the same pattern as we’re experiencing now. So the NIPA margins have been going down for, I don’t know, 15 quarters. Many, many quarters. And the S&P 500 market has been going straight up.
Tobias Carlisle:
What’s the difference between the two? Perhaps just give us a definition of NIPA.
Stephen Clapham:
So I’m not sure that I’ve even got a definition of NIPA. NIPA are the economic margins and I think the source data is the … they’re U.S. margins as filed with the [Inline 00:28:36] Revenue Service is my understanding. So they include not just the S&P 500, but they also include small and medium enterprises. So there’s some good reasons why the NIPA would be different than the S&P 500. The S&P 500 includes some big tech stocks that are making lots and lots of money. The NIPA margins include them, but they’re much smaller proportioned. Small and medium sized enterprises, many of them have been getting squeeze in the last ten years, and therefore they’re declining in profitability rather than increasing profitability.
Stephen Clapham:
The difference between these two sets of data is wide as it has ever been. The interesting thing about this is they often part ways but they always close together. Every cycle has been the same. So you see a segregation and then a meeting again. I’ve got no reason to imagine that this will be any different. They might not meet exactly. There might be a small gap. One of the reasons is the recent changes in the U.S. corporate tax structure and the corporate tax rates and the encouragement to invest by having 100% allowances. The fact is that S&P 500 margins have been going straight up and the NIPA margins have been going straight down, and what I take this to mean, and it’s only my interpretation. I can’t prove it but my belief is that what’s happening is the S&P 500 are lying and the people don’t lie to the tax man.
Stephen Clapham:
There’s a guy, Dougie Ferrans, he’s an old friend of mine and he used to run Scottish Amicable which was one of the largest investors in the U.K. and he used to be the CIO and he used to say to me, “Steve, there’s two people that know what a company really makes. One’s the finance director, the other’s the tax man.” He was always very suspicious of low tax rates.
Stephen Clapham:
Now, there are legitimate reasons that tax rates have come down. You look at a company like Microsoft, which is financially incredibly clean. Its tax rates have fallen very dramatically in the last 20, 25 years, and that’s a function that corporate tax rates have fallen and because there’s more loopholes that companies are exploiting. The NIPA margins and the S&P 500 margins, I will bet you they converge again in the next five years.
Tobias Carlisle:
Oh, I’m with you on that bet. I’m not taking the other side of that bet.
Stephen Clapham:
You know what’s going to happen. It’s not that the NIPA margin’s going to go up, right? It’s the S&P 500 margin’s going to go down. It’s just another indicator that companies are cheating, and this is why people should … they need to be so much more familiar with the accounting than they are.
Beware Companies With Complicated Accounting Policies
Tobias Carlisle:
Let’s talk about an individual name, or a few. Are you familiar with Tesla?
Stephen Clapham:
Oh, I don’t … I’ve got … people are so, so upset about Tesla. I don’t really have a view on the stock, and I do think some of their accounting is very questionable. I’ve had a number of debates. Baillie Gifford, so full disclosure here. Baillie Gifford is one of my largest clients. Baillie Gifford are fantastic, gifted investors and I love going up to Edinburgh and doing the courses there because I always get engaged in great debates. They were very funny. I did the first course and I went up and I said … and Netflix appears in my course, because Netflix is dirty in the accounting side. I said, “I’m very sorry, but I’m going to talk about Netflix,” and they go, “Don’t be sorry. We’re interested.”
Stephen Clapham:
One of the reasons they’re so successful is they’ve got very open minds. Strong views loosely held. They’re very interested in the counter argument, and it’s so important for investors to be able to do that. Not all professional investors have got that open a mind. We’ve had a number of debates about Tesla. We’re working on the Tesla account, actually, at the moment and we’re thinking about doing a webinar series on going through the Tesla accounts and here’s the thing. The trouble with Tesla is it incredibly complicated and it’s very difficult to know what the numbers should be because you don’t have a steady state. It’s been growing very quickly so you can’t say, “Oh, this ratio has moved and that’s an indicator of a problem,” because that ratio could have moved for any one of five reasons because they’ve opened a plant in China, they’ve increased the volumes of the model. There’s numerous, numerous reasons why the numbers change.
Stephen Clapham:
So Tesla’s quite a difficult one, but it’s got … some of the policies are weird. So I got pulled up for talking about their trade in policies. Now, in the U.K., to my knowledge they don’t take trade ins. I understand by the barrage of abuse I received on Twitter than in America they’ll take a trade in. Thank you. I’m now better informed. The problem is, I had one guy in particular just really giving me such a hard time, such a hard time on Twitter about the trade ins. So I said to him, “Thanks very much for pointing this out. I hadn’t realized that they took trade ins in the United States. Can you, then, explain the trade in accounting policy, because it’s written in English but I don’t understand it.” He couldn’t explain it.
Stephen Clapham:
When you read accounting policies, in my experience, good companies have simple accounting policies which clearly explain what they’re doing in accounts. Companies which cheat don’t, and so the more complicated the language, the more difficult it is to understand, the more likely it is that they’ll be cheating. It’s not an automatic 1:1 correlation causation, but what I’ve found is that companies that are cheating tend to throw up a fog around what they’re doing to make it more impenetrable and so as soon as I read a set of accounting policies that are difficult to follow, my hackles get up. I then think, “Ah, here’s a potential shore.” Tesla, that fits that.
Tobias Carlisle:
One of the things about Tesla, one of the things that makes Tesla very difficult is that rapid growth often consumes cash flow and so that’s one explanation for the lack of cash flow, but another one is just that the revenue numbers seem to be very impressive for the most part, although last year it was like 2% growth, but the cash flows have not followed the revenue numbers. They’ve been flat or negative for the most part.
Stephen Clapham:
In a way, if it was a perfectly legitimate and beautifully accounting everything super clean, it might not generate cash, right, because there is all sorts of reasons why it might not be generating cash. It’s going through a massive amount of re-profiling of its production facilities and the way it produces the product. It’s opening loads of new factories. These companies are changing very rapidly can be quite difficult.
Stephen Clapham:
A good example of this is Aston Martin in the U.K., where they’ve not been generating any cash and they’ve been doing a lot of cost capitalization and in the case of Aston Martin it’s obvious that the company came to the stock market at the wrong price. Now, you could argue about Tesla’s stock price and we’d be here until it’s bedtime. There are arguments for and arguments against. I mean, the arguments against I think are more powerful and more plausible at this level it’s been at recently. You can make the arguments in both ways, but I think the Tesla accounting is very opaque, very difficult to understand. The cash flow may or may not be as you would expect. It’s just very, very complicated and if they were cheating, would anybody be surprised?
Earnings Manipulation Is Closely Correlated To Management Incentives
Tobias Carlisle:
When you’re looking at different industries and sectors, do you find that there are any that tend to cheat a little more than others or any that are more suspicious than others?
Stephen Clapham:
Everybody asks this question. Are there particular sectors that are prevalent to this. I don’t think so. I mean, I’ve found frauds in every sector you can imagine. Now obviously look, if you’re in mining or oil, it’s easier to commit a fraud because you find gold and we’ve found gold and there’s lots of it. Those are things that you can’t substantiate with the financial data because the gold hasn’t yet been shipped. So you get those sorts of frauds in those sorts of sectors, but when you’re talking about financial fraud, when you’re talking about earnings management, I believe earnings management is all-pervasive. It’s everywhere, and it’s particularly pervasive in the United States because of the compensation awards.
Stephen Clapham:
I don’t think there’s a sector that’s immune and I think you see it in lots and lots of sectors. Something like a regulated utility, there’s less incentive to do so, but everywhere else, I would say that you’re seeing a lot of manipulation.
Tobias Carlisle:
Do you have any classic examples of fraud? We’ve discussed Parmalat briefly, but what about Enron? Are you familiar with Enron?
Stephen Clapham:
Yeah, I’m familiar with Enron. It’s really from another era because it’s one of these ones where … I think if I remember correctly, Enron was on 60 times earnings when it was making a 6% return on capital. And Enron’s a classic case of look at the returns, because if it’s a good business, it’ll make high returns. Enron wasn’t making high returns because it was fabricating everything so it had all these assets on the balance sheet.
Stephen Clapham:
I mean, the ones that … well, I’ve looked at a number of ones. The one that we’ve been looking at most closely recently is Patisserie Valerie, which we already mentioned. Also in the U.K., we’ve got a case study on a business called Polly Peck which went bust in the early 1990s. It was another one of these ones where they were fabricating the cash, but it was very obvious. Here was a company that was reporting $160 million in profit, and it was reporting interest income of, I think it was $70 million, and interest cost of $55 million. But it had massive debt. It was reporting net interest income, yet it had significant long term and short term debt on the balance sheet and not much cash.
David Einhorn – “People like stories. People don’t pay attention to the numbers”.
Stephen Clapham:
You don’t need to be clever to spot these things, just some very simple, basic checks. Just ask yourself, “Do these things make sense?” Enron seemed to me the classic case of the narrative leading the story and people ignoring the numbers. I have this slide in my courses, it says … and it’s a slide that’s just full of numbers, and it says, “Numbers over narrative.” We have this great couple of slides that we talk about, which is I’ve got a picture of David Einhorn. I don’t know if you’ve read David Einhorn’s book. He wrote the book about insurance scam.
Tobias Carlisle:
Yeah, I have.
Stephen Clapham:
I emailed him and I said … I’m not friendly with him or anything else, but I’ve had some email dialogue with him about ideas and stuff. He’s a very nice chap, it seems. He seems to be approachable, anyway. I emailed him and I said, “David, I enjoyed the book but what I didn’t understand was you’re David Einhorn, you’re saying this company’s making up the numbers, it’s obvious they’re making up the numbers. Why did the sell-side not listen to you?” I was quite surprised that he email … but he emailed me back a couple of weeks later and he said, “People like stories. People don’t pay attention to the numbers.” There’s all sorts of evidence of this.
Stephen Clapham:
There’s a study don by two academics at University of Notre Dame which found that report and accounts are only opened 28.4 times on average on the day of filing and the following day. You think, “Well, that’s just impossible,” right? It may be that people will open them via Bloomberg. That’s perfectly possible, but there’s only 300 thousand Bloomberg screens in the world, and they’re not all owned by equity investors and there’s a lot of equity investors in the world.
Stephen Clapham:
There was a great interview done by the CFO of GE. I think the interview was done in 2015, and he said that in 2013 the GE annual report was downloaded … I can’t remember, it was like 13 hundred times. In 2014, it was downloaded 34 hundred times from their website. But GE’s got millions of shareholders. Admittedly, you could download the GE accounts from the website and you’d be none the wiser because the accounts were nonsense. It just amazes me, how can people own an investment and not have opened the accounts? It’s just bizarre. I just don’t begin to understand that.
Tobias Carlisle:
John Kenneth Galbraith used to call the difference between the reported numbers and what was actually happening underneath as the bezel.
Stephen Clapham:
The bezel, yeah.
Most Companies Will Use This Turmoil To Re-Base Their Earnings
Tobias Carlisle:
And the bezel was often only revealed in the crash or after the crash, and so I just wonder this time, given that we’re having a coronavirus slowdown, or it’s going to be blamed on coronavirus. I have a theory that the yield curve inversion occurred here in June or July last year and there are many, many indicators that the world was going into a slowdown and I think coronavirus is sort of the catalyst or the trigger rather than the underlying root cause. But I fully expect that they’re going to use this quarter to big bath a whole lot of accounting, and so I think there’ll be some horrible accounts that come through the other side. Are there any companies that you might be looking at that you think might show their true colors in the next quarter or so?
Stephen Clapham:
It’s difficult to single a few companies out, because I think they’re all asset. The companies that don’t I think will be exceptional. You’re laughing, but let me tell you, I went to probably 20 analyst meetings at the time that I was building the forensic accounting course, so the second and third quarter of 2018. 15, 20 analyst meetings. Every single meeting I went to, I came away with an example of accounting chicanery that I used in the course. There wasn’t a single meeting that I went to that I could not find some name that they were doing wrong.
Stephen Clapham:
Now, I’ve been doing this for a long time, and admittedly, normally I go to analyst meetings, I’m thinking about investment. But I’m an account space analyst, and if companies are cheating, I would always go, “Oh, that looks a bit naughty.” I don’t recall a period, and I’ve been doing this for a long time. I don’t recall a period ever when companies were cheating as much. So if you can find me a company that comes out the other side of this horrible situation without adjusting its numbers, I’ll be very surprised. I’m sure there’s one. I’m sure there’s a dozen, but honestly 90% … more than 90% of the companies will be using this as an opportunity to re-base their earnings.
Stephen Clapham:
I’ve been getting a lot of very bullish comments. We’re doing this the day after Bill Ackman revealed that he made 100 times his $27 million investment, which is absolutely heroic, and that he’s super bullish. I think it was last night or two nights ago, Whitney Tillson called the bottom of the stock market. Whitnye, I salute you. The fact is, that none of us know what’s going to happen on the other side of this virus, but the one thing that you can be absolutely confident of is there is going to be a cash flow squeeze across the world.
Stephen Clapham:
I’ve got a very small business and most of my clients are required to pay in advance. I have a few clients for various reasons I haven’t invoiced. Not one of them has paid me. It may be that they’re all locked away at home and they can’t get to their bank. It’s possible. Unlikely, but possible. I tell a lie, actually. There is one client who’s paid me. It’s very nice that the member of a very wealthy family who’s working in the family office and I’m helping train her one to one in how to look at the accounts and how to analyze businesses and she’s paid me. But she’s a nice person and they’ve got a lot of money.
Stephen Clapham:
This is a microcosm of what’s going to happen. Nobody’s going to be paying each other, and working capital, I think, has been very stretched. I haven’t done a very detailed analysis of this, but I’ve looked at a number of industrial companies where in the last 15 years they’ve massively improved their collection cycle. So collection cycle for a company like Electrolux has gone from 70 days probably to zero. A huge improvement. Maybe it was 50 days and it’s gone to zero.
Stephen Clapham:
So you think, “Whoa, isn’t that fantastic? The company’s become really much more efficient in its use of capital.” It’s become much more efficient but not be reducing its inventory. Its inventory days, its debtor days are flat over the last 15 days. What it’s done, is it stopped paying people. It’s now got a hundred days of payables. Well guess what’s going to happen? Those days are going to shrink. They’re going to have to shrink because all its supply chain is going to be desperate for money. So what you’re going to see is many of your listeners will not even know what a rights issue is. When I started in the stock market, you had to know how to work out the theoretical at the right price. Well, I can’t remember, honestly. I can’t remember the last time I had to work one up. I’d have to go and look up what the formula was, it’s so long since I did it.
Stephen Clapham:
Well, guess what? We’re going to be finding out how to do that very soon because there’s going to be a big change as a result of all of this and the other big change will be you see a load of accounting adjustments.
Non-Gap Earnings – Three Card Monte
Tobias Carlisle:
Last question, Stephen. How do you feel about non-gap earnings?
Stephen Clapham:
I’m torn as to whether to hate them or love them. I love them because they’re going to keep me in business, but I hate them because they are classic … in the courses I use the example of the three cup trick where you’ve got one ball and three cups and you’ve got to watch the-
Tobias Carlisle:
Three Card Monty. It’s a variation of that, right, where you’ve got to follow the queen.
Stephen Clapham:
Yeah, follow the queen. Exactly the same thing. That’s non-gap. That’s follow the queen. It’s exactly the same thing. What you must, must, must do is don’t ignore … I’m not saying ignore the non-gap numbers. Look at the non-gap numbers, but you’re very lucky in the United States that companies are required to give a reconciliation. Go through that reconciliation and throw out anything which doesn’t look right.
Stephen Clapham:
My favorite bug there is restructuring costs. Companies that have restructuring costs year after year after year. GKN in the U.K., I haven’t added it up, but I suspect their restructuring costs were as much as their EBIT. Certainly they were as much as their earnings. I mean, over a 15 year period, every single year they had huge restructuring provisions. I’ve got loads and loads of examples of it. That is one thing that you want to be very wary of when you’re looking at the non-gap numbers, but there are lots of adjustments and most of them aren’t right.
Tobias Carlisle:
Stephen, it’s coming up on time. If folks want to get in contact with you, how do they go about doing that?
Stephen Clapham:
Well, you can follow me on Twitter. @steveclapham C-L-A-P-H-A-M. You can come to my website, behindthebalancesheet.com. You can see … we’ve got a whole bunch of online courses there. Please do go there, and we’ve got two things which your listeners should enjoy. One is we’ve got a library, so if you click on Free Tools, you can get access. We’ve got a library with a huge amount of free stuff, all investment related. Loads and loads of investment letters. Loads of interesting stuff.
Stephen Clapham:
Another thing we’re doing right now because everybody’s stuck at home, we’ve got this program, we call it Thirty Thirty. So if you go behindthebalancesheet.com/3030, you can sign up for our new program. So this idea came about … I’m trying to reinvest some of my commuting time and I’ve started this Couch to 5K, which we’ve got in the U.K., which is thing where you learn to run, right? I’m not a runner, but hopefully by the end of this, I’ll be running 5K. The idea of this program is that you sign up and every day, we give you something to read, something to watch, something to listen to, I’m sure some of your podcasts will be recommended, or something to do, we’ll do some exercises. So everyday for thirty days, we’ll give you a little thing to keep you busy. You’ll spend thirty minutes or less and hopefully at the end of it, you’ll have learned something and you’ll be a better investor.
Tobias Carlisle:
That sounds like a great initiative. Stephen Clapham. Behind the Balance Sheet. Thank you very much.
Stephen Clapham:
Thank you, Toby.
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