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Ben Strubel is the President and Portfolio Manager of Strubel Investment Management, LLC ("SIM") a registered investment advisor. Strubel Investment Management provides separate account management services for clients and also publishes The Value Investor's Edge Newsletter. Ben Strubel... More
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  • 10 Lessons for Investors in the Wake of the CCME Scandal: Part I 3 comments
    Mar 31, 2011 10:16 AM | about stocks: CCME, ONP, CSKI, UTRA, WATG, DEER, ABAT, CAGC, DYP, CMFO, CEAI, CHBT, BORN, SHZ, ZSTN, FUQI

    I have been watching the saga surrounding Reverse Takeover (RTO) Chinese Small Cap companies with morbid fascination. Although we had and have no financial stake in any of the companies (our primary custodian, FOLIOfn, does not allow short selling and we certainly weren’t going long!) the ongoing saga highlights some powerful lessons for all investors--not just the ones caught up in Chinese RTO frauds. In the first part of this two-part series, we will look at lessons involving investor behavior and the role of auditors and large institutional investors. We can all learn from the mistakes of others. Here are 10 tips or lessons we can learn.

     

    Start Off Being Skeptical and Not Trusting

    Of all the behavioral biases humans have, perhaps none is more dangerous as confirmation bias. After making a decision, humans tend to seek out information that confirms that their original choice was the correct one and to ignore contradictory information. Once our opinion has formed people tend to view information or reports that confirm their decision as correct and those that don’t as wrong. Rather, we should objectively examine the new information.

     

    Investors should start off being skeptical of all claims that management makes and have the attitude that a company is a bad investment until proven otherwise. The first thing I do when beginning research on an investment is seek out every negative article or research report I can find on the company. I also make it a point to talk to any analyst or fund manager that has sold the company short. Only once I have gathered all the negative information on a company do I then start to think about whether all the information is true or is there is another side to the story that is worth researching.

     

    Social Proof Has No Place in Investing

    "You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right." –Ben Graham

     

    In his book Influence The Psychology of Persuasion, Dr. Robert Cialdini relates an interesting story showing just how bizarre a phenomenon like social proof can be. There was a cult in Chicago that believed aliens were coming at midnight on a certain date to take the members away from a flood that would destroy the world. On the appointed night when they gathered in the leader’s home, nothing happened. Faced with undeniable proof that their original beliefs had been incorrect, they did something that seems strange. While they had previous been relatively secretive and shunned the media and made no effort to attract recruits, they now began spreading their message in earnest. They began massive efforts to attract new recruits and regularly began contacting media outlets to spread their message. Why did they do it? They had gone too far and given up too much. They could not face the possibility that their belief was false. Many had quit their jobs and given away their life savings and possessions. To make that sacrifice seem worthwhile, the only proof left that they could muster up was social proof. That is, if they could recruit and convert many people, then they could surround themselves with others who believed as they did and could convince themselves that their sacrifices were not in vain.

     

    While the story may sound bizarre, it is not so different than what many investors do. While confirmation bias keeps many investors from even considering contradictory information, even when the evidence is clearly overwhelming those investors do what the cultists did. Instead of having an intelligent discussion about the substantive issues, many shareholders take to the proverbial streets, in this case internet message boards or blogs, and begin seeking more recruits.

     

    What should investors do instead? When the evidence becomes overwhelming that you are wrong, admit it and sell. The ending for most China RTO frauds follows the same pattern: a trading halt followed by a delisting from a major exchange before finally trading over the counter for a small fraction of the share price. But before their stocks met their end on the OTC market, many individual shareholders were faced with overwhelming evidence that they were in far over their heads. At that point they had the chance to sell with far smaller losses. Instead of admitting they were wrong, many chose to surround themselves with yes men who knew as much or less than they did.

     

    Be an investor not a cultist.

     

    If It Is Too Good to Be True, It Is

    In a business environment that is more competitive than ever due to globalization, investors should be skeptical of any company earning outsized profits or growing well above industry rates. For a company to earn outsize profits in a competitive environment, it needs some sort of durable economic advantage. Examples include Philip Morris International whose strong brand name, habitual purchases by consumers and addictive product provide a moat. Microsoft can leverage economies of scale and high switching costs for its Windows and Office franchises to earn outsize returns. High growth comes from launching new and innovative products such as Apple and its many consumer electronic hits such as the iPod, iPhone, and iPad.

     

    Contrast this with many of the fraudulent Chinese RTOs. They were in boring commodity businesses such as fertilizer, jewelry, industrial equipment, advertising, generic and/or eastern pharmaceutical sales that offered no competitive advantages. Management’s explanation for how the companies earned profits at three or four times industry averages were always weak and implausible. Some of the weak reasons were good cost control, good management, and various spurious special licenses or agreements.

     

    If a company is wildly successful according to the financial statements it files and a whole slew of competitors who are trying to emulate it fail to make similar splashes, than the company deserves very thorough scrutiny.

     

    Auditors Don’t Audit

     “If only 20% of financial statement users think the auditor’s opinion is worthless, it means 80% of investors are dumb.” –Sam E. Antar via Twitter

     

    Audits are designed to give investors reasonable assurance that the numbers reported on a financial statement are materially accurate. Audits are not designed to detect fraud, and audits are not designed to give absolute assurance that the numbers are accurate.

     

    The Public Company Accounting Oversight Board (PCAOB) says: “Audits typically involve testing a sampling of data and exercising judgment about audit evidence – what to collect, how much is necessary, the extent and nature of testing, and the best way to gather it. Because auditors do not examine every transaction and event, there is no guarantee that all material misstatements whether caused by error or fraud, will be detected.”

     

    At least the auditors decide what audit evidence to collect and test, right? Well, not so much. It is important to remember that auditors are hired and fired at the discretion of management. It’s like criminals getting to hire the police officers that are charged with catching them. And management has plenty of ways to keep auditors in line. Whether it’s the Enron approach (now mostly curtailed) of dangling lucrative consulting deals to get favorable treatment, the Crazy Eddie booze-and-schmooze approach, or just flat out hiring small incompetent or unscrupulous auditors, management has plenty of tools to keep its most complex fraud undetected for years.

     

    Turning to Deloitte and its audits of China MediaExpress, why didn’t Deloitte find any problems in its 2009 audit? The explanation is likely very simple: They weren’t looking for any. Only after short sellers and other parties contacted Deloitte and/or the Audit Committee and Board of Directors and told them under which rocks to look did they begin to find the problems that had been there all along.

     

    Finally, having a top-rated auditor doesn’t mean the financial statements shouldn’t be heavily scrutinized. While it was ludicrous to believe that tiny accounting firms based in the U.S. with less than a dozen people could conduct thorough audits of multiple Chinese companies, having a large auditor isn’t a free pass either.

     

    A small sampling of recent shame for some top auditors is below. The scams perpetrated and slipped past auditors run the gamut from the mundane, such as improper recognition of revenue, to the incredible, such as hiding massive amounts of off-balance-sheet liabilities or falsifying billions of dollars of cash.

     

    Arthur Andersen (now defunct): Enron, WorldCom, Nicor, Global Crossing

    Ernst & Young: Lehman Brothers, Anglo Irish Bank, HealthSouth

    KPMG: Allied Capital, Peregrine Systems, ImClone, Xerox

    Deloitte: Nortel, Royal Ahold, Reliant Energy

    PwC: Satyam Computer Services, AIG, Tyco

    Grant Thorton: Parmalat

     

    In short, neither a small two-partner shop nor a name-brand multinational auditor nor the PCAOB is going to look out for you. Only you can look out for yourself.

     

    Analysts and Institutional Investors Won’t Do Your Due Diligence for You Either

    Even if investors acknowledge that auditors can easily be fooled or if a firm has an auditor that is viewed as less competent than a big-name auditor, they sometimes point to other large institutional shareholders of a company and assert that “ABC company can’t be a fraud if XYZ invested in it.” With CCME, it was C.V. Starr & Co run by ex-AIG CEO Hank Greenberg that investors pointed to as proof that CCME was legitimate. Again, as with the auditors, you have no idea how much due diligence those other investors did. Did they take their position because they use a quantitative model? Did they buy the stock as part of a basket of stocks as a sector bet? Or did the big investor actually do their homework?

     

    In his book called Fooling Some of the People All of the Time about the fraud at Allied Capital, hedge fund manager David Einhorn relates the story of his meeting with Wasatch Advisors. Wasatch was the second largest shareholder of Allied Capital, but the portfolio manager in charge of the position had just bought the stock as part of a larger basket and had not done much investigation on Allied Capital. In many ways Wasatch was not familiar with Allied’s business.

     

    Oh, and let’s not forget Enron. Its 10 largest shareholders at the time of its collapse were all Wall Street’s large “smart money” managers, such as Putnam, Barclays Bank, Fidelity, and Citigroup.

     

    Fraudulent Chinese companies have ensnared large sophisticated investors too. Carlyle Group, the world’s second largest private equity firm, had $105M of egg on their face after they bought the fictional China Forestry Group. Publicly traded Heckmann Corporation (HEK) run by Richard Heckmann, who successfully orchestrated the roll up and sale of companies worth a total of almost $10B, was also left holding the bag for the largely fictitious $625M China Water & Drinks. And this was after five months of due diligence by Heckmann, hired consultants, and others.

     

    In other words, other investors--no matter how large and how purportedly sophisticated--aren’t going to do your due diligence for you. You have to be the one to research each investment thoroughly. If you can’t do that, then move on to an investment where you are able to do sufficient due diligence. Warren Buffett made a fortune investing in only what he knew. Great investment returns doesn’t mean investing in small dodgy companies in foreign countries just because they appear cheap.

     

    Part 2 of this series will be posted in a few days. In the meantime, below are some resources about accounting, corporate governance, and spotting fraud that you may find helpful.

     

    Organization Websites

    PCAOB

    FASB

     

    Books

    Financial Shenanigans by Howard Schilit

    Quality Financial Reporting by Paul B. W. Miller

     

    Blogs

    The Fraud Files Blog

    White Collar Fraud

    Going Concern

    Footnoted

    sharesleuth

    Due Diligence

    Harvard Law School Forum on Corporate Governance and Regulation



    Disclosure: I am long PM, MSFT.
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Comments (3)
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  • TruffelPig
    , contributor
    Comments (4068) | Send Message
     
    Well, I definitely will NOT invest any money in Chinese companies anymore until they have better regulation. That there is always a chance for fraud is clear. The biggest ones you didn't mention actually - the US and some other banks. Trillions of dollars in capital loss for investors, or did I miss something? This CCME thing definitely has sharpened my senses. What I feel is terrible though is that NASDAQ allows to halt stocks. Let capitalism play it out. The result - stock at 0 - is eventually the same.
    1 Apr 2011, 07:40 PM Reply Like
  • TruffelPig
    , contributor
    Comments (4068) | Send Message
     
    Addition: This halting is just good for peeps like Greenberg to get out while the small investor can't.
    1 Apr 2011, 07:41 PM Reply Like
  • zzen
    , contributor
    Comments (13) | Send Message
     
    Really excellent article.
    5 Apr 2011, 07:52 PM Reply Like
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