People, I’m in need of your wisdom. How do I spot fraudulent Balance Sheets? Is there any way to reliably evaluate a Balance sheet’s validity in hindsight? If you have spotted an investment with a huge Margin of Safety, but presumably because the books are cooked, will you invest anyways (given that you have no proof for your allegations)?
Erik Malmberg: A great question.I would never, ever, invest in any enterprise that had even a shadow of suspicion to be fraudulent, corrupted or criminal. Because those will ultimately aim to defraud you and all the other investors. Even if this isn’t the main idea. Or they get caught, which in effect will mean that you anyhow will lose your investment.In the given example of the huge margin of safety I would say that this of course must be the essence of the trick to lure you to give away your money. And thus a big no no.Spotting cooked books is naturally difficult, or even impossible for a layman, but the easy rule is – if it sounds too good to be true, then it is a fraud. Always and without any exception.Therefore always make sure that the burden of proof is on them. They have to show you that your investment is secure, trustworthy and with a healthy risk/reward balance – otherwise there are thousands and thousands of other, much more attractive, investment opportunities.
Ibrahim Özcan: Let me rephrase the initial question: How have other investors historically spotted frauds, such as Enron, Worldcom etc.? Maybe there is some pattern.
Michael Wei: Several red flags: off the balancesheet liabilities, related party transactions, special purpose vehicles (SPV), variable interest entities (VIE). When you see those, dig deeper.
Ken Aguilera: Think about it, a company will commit fraud to make the balance look great …but you are value investing, which means you are actually trying to look for companies whose balance sheet looks not so great. That’s the point, anybody can put their money on a great company with great financials, not everyone has the fortitude to look at subpar companies…that’s what we are trying to do
Ibrahim Özcan: So you should never invest in Net-Nets? Because a balance sheet with more cash than debt sounds pretty good to me
Ken Aguilera: Of course but think about it, net nets are usually beat up by the market because the ly are “seen” like garbage, whereas pristine companies are usually valued higher. Think about Enron, everybody thought they were “the best” company in their industry, …See more
Ken Aguilera: I only focus on net nets, I’m always looking for the stuff no one looks at, and it works.
Ibrahim Özcan: Are your net nets profitable?
Ken Aguilera: 9 times out of 10 yes. You run into a value trap here and there, but if the stock doesn’t take off, some other company comes and buys them out
Ibrahim Özcan: I’m dealing with a profitable net-net right now. That’s what makes me suspicious.
Ibrahim Özcan: The position makes up of ~1/3 of my portfolio, which i’m comfortable with.
Ibrahim Özcan: I only hold it for 3 weeks so I have no basis to judge if it’s working or not. But I’m slightly in the green as of today.
Ibrahim Özcan: Yeah
Ibrahim Özcan: Don’t know about berlin and munich yet but düsseldorf and frankfurt are awesome! Yeah it’s pretty cold right now, so not the best time for a visit 🙂
Ibrahim Özcan: No not really. I think I would feel more free in the USA. My background (ethnicity) is kind of a handicap. But it’s not too terrible.
Ibrahim Özcan: I was born here
Michael Wei: Try read Enron’s 10-Ks and 10-Q in 1999, 2000 and 2001 and see for yourself: https://www.sec.gov/cgi-bin/browse-edgar…https://www.sec.gov/cgi-bin/browse-edgar…
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William Goh: When people want to conceal, they do everything to conceal. They plan a long time to conceal. Maybe there’s a team of people colluding to conceal a fraud. Auditors sometimes can’t conclude the existence of frauds after they look at the accounts in details!You’d win some nobel prize if you could identify frauds just from the balance sheet.
Michael Wei: It’s more than just balance sheet. It’s the footnotes. What does the following tell you? It smells.8. RELATED PARTY TRANSACTION…See more
Alessandro Orlandi: good question! 🙂
T Aaron Brown: Definitely watch for an inflated goodwill and other intangible assets. Upon follow-up, can you make sense of the allocation/valuation.
Rob Urban: Large goodwill balance. Net income consistently much higher than cash flow. Consistent use of “adjusted earnings” or “adjusted EBITDA”. Large mgmt stock options with little restricted stock ownership. Reading the 10-K and the CEO optimistically glosses over major challenges rather than giving it to you straight, is so RUN away. Quarterly reports where mgmt talks about major changes in the industry and how the company is “leading” the change, investors don’t want change, change is bad for cash flow and is impossible to value. Finally, if your gut is nervous, avoid as your 6th sense is telling you something. This will get you started.
Allen Kaplun: If all the numbers look “perfect” and the stock is low theres a good sign of fraud. If the price is roaring, then examine the financials closely and try to get your best understanding of how their business operates. Watch out for conflicts of interest and financial engineering.
Mauro Bruno: If you want to understand more on this subject, there’s a great book by Howard Schilit. Look for “Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports”