Quick Ways To Spot Company Frauds Or Manipulations

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During his recent conversation with Tobias, Stephen Clapham, founder of Behind The Balance Sheet, discussed Quick Ways To Spot Company Frauds. Here’s an excerpt from the interview:

Tobias Carlisle:
When you’re examining companies … so you’re a detailed 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.

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