Sensible capital allocation

One major red flag is when a company spends a huge amount of money to raise capital when it doesn’t need to. You should always ask yourself why the company decided to raise capital.  If a company with a large amount of cash on its balance sheet decides to raise capital, it is probably because the company thinks that its shares are overvalued.  The next question is to ask why the shares are overvalued.  Sometimes there is fraud involved and sometimes there isn’t.  In a fraud, the company will appear undervalued while insiders know that the shares are overvalued.

Where there isn’t fraud involved, it is generally a good idea to stay away from the company anyways.  If the company is raising capital despite having lots of cash available, it is highly likely that the company is overvalued.

Cost of capital

Any company paying more than 10% interest on some of its debt is likely very distressed.  In almost all areas of business, it is extremely difficult to earn more than 10% on invested capital.  Those businesses which are able to earn unusual returns on invested capital often cannot reinvest all of their earnings back into their business. Wonderful businesses tend to throw off excess cash and do not need to raise capital.

If a company is legitimate, it will not take on debt at onerous terms unless it is forced to because it is distressed.

If a company is a fraud, it makes a lot of sense for fraudsters to raise capital on onerous terms.  They can use the cash to keep the fraud going.  Or, they may simply find ways to transfer the money to themselves.  If the company’s income statement suggests that it is highly profitable (and therefore not distressed), then you should suspect fraud if its cost of capital is extremely high.

Investigative work

Some short sellers will hire private investigators to verify the existence of assets.  With many Chinese reverse mergers, this strategy made a lot of sense.

1. Many Chinese reverse merger frauds told lies.  They pretended to have assets that did not exist.
2. Many Chinese reverse merger frauds paid another company to “borrow” their factories and facilities.  Workers would put up signage for their company.  Then, foreign investors were taken on “due diligence” tours of the borrowed facilities.

Some short sellers post their investigative work online.  Some skepticism is warranted because many of these reports are one-sided hit pieces.  The short sellers posting their work often want to see their research targets implode so that they can generate a high rate of return on their short positions.  Some short sellers buy puts right before they release their report.  Nevertheless, there is a lot of good research available online.

Do the numbers make sense?

If earnings are being inflated, there will be some type of fictitious asset on the balance sheet:

1. Fake cash.  In theory, cash is extremely easy to audit.  In China, some bank employees have helped frauds by issuing fake bank confirmations.  Outside of China, auditors have been fooled on rare occasions.  (“Hey, let me help you fax that bank confirmation.”)
2. Fake PP&E.  Over long periods of time, return on capital will drop as fake PP&E accumulates on the balance sheet.  One way to check if assets are being faked is perform investigative work and visit the assets.
3. Fake intangibles.
4. Fake receivables.  Over time, fake receivables will cause the days sales outstanding metric to continually grow.  Aging of receivables may also go up.  There may also be a mismatch between the company’s credit terms and the age of the receivables on its balance sheet.
5. Fake inventory.  Over time, inventory turns will come down.

Statement of cash flows

If you suspect that expenses are being improperly capitalized to create fake PP&E, then you should look at free cash flow: earnings + D&A – capital expenditures.

If you suspect that inventories or receivables are being faked, then you should look at income from operations – capital expenditures.

Comparable companies

Another way of checking the numbers is to compare a company against its peers:

1. Do the margins make sense?
2. Does the return on capital make sense?
3. Do inventory levels make sense?  (e.g. inventory turns)
4. etc. etc.

Fake revenue growth

Sometimes Wall Street likes to see growth, even if it is only revenue growth that hasn’t yet translated into growing profits. It can make sense to investigate the revenue figures to see if the company is engaged in “round tripping”.  The company may be improperly recording offsetting revenues and expenses that cancel each other out.  While this will not inflate profits, it will inflate revenues and create the illusion of revenue growth.

I believe that looking at PIERS US import/export data would be one way to verify revenues.  Other methods would be to look at 3rd part web traffic stats (e.g. Alexa, Comscore), Google Trends, etc.

Understand the industry

If you understand an industry well, you will know which metrics are important and how management teams might try to deceive investors.  You would also know if a company’s numbers are too good to be true given what the company does.

Frankly, many investors do not understand what they are investing in.  (I am one of those people.  I’ve definitely invested in things I don’t understand.)  Those who understand an industry well would be able to figure out the following:

1. Who the superstars are.
2. Who the fraudsters are.
3. Which metrics are important.
4. Which metrics aren’t important.
5. What the major accounting distortions are.
6. How a company’s accounting can be manipulated.

Insiders take their reputation way too seriously (weak red flag)

When short sellers attack their company, some fraudsters (though not all) spend way too much time and effort in defending the company’s reputation.  Rationally, fraudsters should try to act like legitimate management teams.  Overdefending the company is a tell that the company is a fraud.

Or, fraudsters should simply “preach to the converted”.  The people who fall for frauds are not the smartest people around.  Fraudsters do not need to use very sophisticated arguments to convince these people that the company is not a fraud.  A rational approach would be for the fraudulent management team to make ad hominem attacks against the ‘evil’ short sellers for trying to conduct a bear raid.  It doesn’t really make sense for them to selectively rebut factual evidence that their company is a fraud.

This red flag is not the strongest sign that a company is a fraud however.  Legitimate management teams may defend their reputation vigorously if the short sellers are hurting the underlying business (e.g. a party shorting HLF has purchased advertising on Google in a campaign to inform the public that Herbalife is a pyramid scheme).  Legitimate management teams may want their shareholders to value the company accurately so that their shareholders aren’t getting hurt by selling their shares too cheaply.

Insiders damage the company more than the short sellers

Some fraudsters waste shareholder money in response to attacks by short sellers.  They may use shareholder money to wage expensive legal battles against the shorts.  Historically, management teams that decide to sue short sellers tend to see their share price drop significantly.

Legitimate management teams will not waste money unnecessarily in fighting short sellers.

Management’s integrity

In general, human beings are wired with a certain degree of integrity and kleptomania (the inability to refrain from the urge to steal).  People who have done shady things in the past tend to do so again in the future.  In my opinion, it is extremely important to avoid shady people in the stock market.  While they may not commit fraud, they will often find ways to line their own pockets at the expense of shareholders.  The risk/reward when dealing with shady people is unattractive.

Do not confuse altruism with integrity.  Many fraudsters will donate money to charity and give favours to others.  Bernie Madoff for example was involved heavily in charity work.  Integrity is about avoiding unethical behaviour.  Before Bernie Madoff ran a Ponzi scheme, he was pioneering methods of fleecing retail investors by giving kickbacks to brokerages in exchange for order flow (“payment for order flow”).

Insider selling (weak red flag)

Fraudsters generally sell stock.  But so do legitimate CEOs.  This is not a foolproof red flag.

This red flag is a little stronger if the insider selling is done through a secondary offering.  Secondary offerings are pretty expensive as the shares have to be sold at a discount and because the underwriters take very large fees.  Insiders generally take advantage of secondary offerings when the stock is overpriced.  While fraud is more common whenever a secondary offering is involved, many parties choose a secondary offering simply because the shares are overpriced.

Insiders are secretly selling their shares

There are some situations where you can infer that insiders are selling.

Suppose you have a company that is paying for blatant stock promotion and is issuing a regular dividend.  Blatant stock promotion only vaguely makes sense for shareholders if the company intends on raising capital.  Issuing a dividend returns capital to shareholders.  If the company will not be raising capital and insiders are not officially selling, then you can guess why the company is paying for blatant stock promotion.  Insiders are probably selling… they just aren’t reporting it.  If insiders are willing to engage in illegal insider selling, they might also be willing to engage in fraud.  While there may not necessarily be fraud involved, pump and dumps are designed to be scams.  You should probably copy insiders and sell.

Paid stock promotion

Stocks that are heavily pumped tend to have higher levels of fraud.  Regardless of whether or not there is fraud, you should probably sell these stocks.

The pump and dump industry

Pump and dump is an industry.  One you figure out who the players are, you can make an educated guess as to which stocks are likely to be pump and dumps.

Areas of the stock market where fraud is unusually high

1. Reverse mergers, especially Chinese companies.
2. Foreign stocks where insiders would be difficult or impossible to face justice if they were to commit fraud.  This is a magnet for fraud.
3. Special purpose acquisition companies.  For whatever reason, SPACs tend to merge with frauds.
4. Mining, especially junior mining stocks.
5. Independent oil and gas.  Resource stocks are magnets for fraud because it is legal to inflate resource estimates.
6. Development-stage pharma.  This area is a magnet for fraud because management can legally make overly optimistic projections about the future.
7. Stocks with very expensive borrows or very high short interest.  (See my post on guessing the short thesis.)
8. Nanocaps/microcaps.
9. Stocks listed on smaller junior exchanges such as the TSX Venture, AIM, OTC BB, Pink Sheets, etc.
10. Penny stocks.  Pump and dump scam artists intentionally keep the share price low so that the shares are incredibly difficult to short.  These scams are generally found on junior exchanges where there is less scrutiny from the exchange and regulators.

Any stock that falls under #1 through #7 deserves extra scrutiny.  Most of the stocks in those areas have some degree of fraud involved.  #8 and #9 are areas of the stock market with less fraud and more legitimate companies.

Finally… a caveat

In reality, most frauds have a real operating business attached to it.  While complete frauds exist and some of them have market caps that are a few hundred million or higher, complete frauds are rare.  When analyzing such companies, you should analyze both the fraudulent part of the company and the real business that is attached to it.