Falling for Fraud
This week we discuss fraud, JPM's Guide to Markets, and a succinct thesis on Google.
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Latest Blog Post
Falling for Fraud
As economic conditions deteriorate, many things happen. The market corrects, stock prices fall, jobs become scarce (usually), and lending tightens up. It's usually bad all around. But one of the ‘good’ things that happens is that frauds are uncovered. I put good in quotations because even though it’s a positive to expose frauds, the existence of a fraud usually means there are victims of it, which is never good.
These past 12 months has uncovered several frauds. From known ones like FTX to this insane story about how the founder of Frank scammed JP Morgan for $175MM. There are alleged frauds such as the Adani Group in India, numerous SPACs and charges against social media influencers who essentially ran pump and dump schemes.
Now, there are various types of frauds. From the phone/SMS/email types that target the elderly to the large corporate types that we are all familiar with. My simple understanding is that while there is a common thread here – lie/cheat/deceit for financial gain (or to hide a financial loss) – the sophistication of both the scam and the target is highly varied. Let’s take two very different examples. First, the well-known Nigerian Prince email scam and then second, what just happened recently with Brazilian retailer Americanas:
The Nigerian Prince scam is well known. You receive an email from a “Nigerian Prince” claiming he needs help to get some money out of Nigeria. If you simply give him your bank details he will let you keep a portion of it. As soon as you do, you find your bank account drained of significant amounts of cash. There are many variations of this type of scam but they all follow a theme of ‘helping’ out someone in a developing country. But if you ever read any of these emails one thing will pop out at you – how bad the grammar and spelling is. You think to yourself – how could anyone possibly fall for this. But the truth is the scammers don’t care – it’s the way they filter the recipients. If you notice the grammar – you’re not really their target. If you don’t, you are. It's an unsophisticated fraud that targets specific victims that still generates $700K a year for the scammers (just in America).
On the other end of the spectrum was a recently discovered fraud in Brazil. Americanas is a retailer (offline and online) selling electronics, snacks, homeware, and much more. While its current iteration (as it was a merger between two other companies) only got going in 2021, it had, at least on the surface of it, a very decent business. Going into 2021 growing GMV by 32%, Net revenue by 28%, with stable gross (~30%) and EBITDA margins (~15%). It was one of the key players in the retail/online space in LATAM and had limited net debt backed by about R$8bn in cash. It turns out, as revealed over the last few weeks, that only about R$800MM of that cash was real and the real debt amount was R$43bn. This is because, according to the FT,
“The R$20bn accounting “irregularity” stemmed from an operation common among Brazilian retailers. Banks would pay Americanas suppliers in advance, with the company then responsible for the repayment of these loans, including interest payments.
These interest transactions, however, were effectively camouflaged by the company, which did not classify them as financial debts. The practice, which resulted in higher reported profits, is believed to have gone on for years.”
The stunning thing here is that the investors base included Jorge Paulo Lemann (Brazil’s richest man), Marcel Telles and Carlos Alberto Sicupira. To those familiar, these three gents are the founders of 3G Capital which owns Kraft Heinz, Burger King and other famous brands. The trio, who owned 31% of Americanas, were also on the board of the company. Thus – assuming they were not complicit as they claim not to be – this revelation means that some of the smartest investors in the world were duped.
Now, I’m not bringing this up to throw mud at anyone. It's just that most of us reading this post would look at the Nigerian Prince email and think – I would never fall for that. The truth is though, we may not fall for that scam, but we will fall for one more tailored for us. The founders of 3G wouldn’t lose a single cent to a “Nigerian Prince” but just lost millions to an accounting scandal.
The point here is, I am not above believing I won’t be scammed in my investing career. I don’t think it’s happened yet, I hope it doesn’t happen, and I will do everything I can to avoid it. But I am open to the possibility that it may happen nonetheless. Many of the big names - Einhorn, Ackman, Sequoia, Ellison, Temasek etc – have all invested in frauds. I believe most investors have to consider the possibility and how they might protect themselves from it.
I don’t know if there is an exhaustive list on how to ‘spot’ a fraud but based on my experience and reading here are some red-flags that might set off some alarms.
A highly promotional or promoted founder: Elizabeth Holmes and SBF were on the cover of several magazines. They were hailed as visionaries and geniuses. Put it this way, whenever someone is labelled as “the next Steve Jobs,” run. Run fast.
A great story: Stories are great, they influence people more effectively numbers and facts do. Stories are often a powerful arsenal when pitching to investors. But all ‘great stories’ need to be verified. The funniest bit about the Frank/JPM fraud is that the CEO of Frank claimed her parents struggled to help her apply for financial aid. It turns out, her Dad worked on Wall Street for decades, and her mother was a successful counsellor. She grew up in affluent neighborhoods. It’s highly unlikely she needed financial aid (source).
An obsession to meet guidance/expectations: When I was in business school one of my most unique experiences was getting to talk to the CFO of HealthSouth. For those who don’t remember, Health South was the big accounting scandal before Enron. One thing he said that always sticks with me was that the fraud started with a minor adjustment to meet guidance that they were about to miss by just a hair. The CEO was obsessed with meeting street expectations and the finance team thought it was ok to oblige just this one time. It was not just one time.
Bullying: Wirecard bullied sceptics, had reporters followed, and even pressured the German regulator to go after short sellers. Bullying in the face of internal/external dissent is never a good sign. Miguel Guiterrez, the CEO responsible for the Americanas mess was known to be disciplined, kept a low profile, and was highly objective. But he was also known for his ‘rude’ behaviour that according to one report “at times, descended into screaming and cursing”.
Short Sellers: As much as one of the biggest dreads as an investor is seeing a short report come out on one of your holdings, it’s imperative you go through them. These reports flesh out several red flags, and your job as an investor, I think, is to assume they are true and then go about trying to prove them wrong (or at least prove them as immaterial). Simply ignoring the report is a terrible way to operate.
One thing to not rely on is the auditor. Jim Chanos (famed short-seller) once responded to the question “who were the auditors” with “who cares?” when talking about a fraud. His point was that every major fraud has one of the big accounting firms in charge. It makes no difference.
The other thing to bear in mind is that the odds of discovering a fraud are against you. I recently read an article by Ted Seides (of Capital Allocators), and in it there was an interesting observation that goes like this:
When you conduct analysis on an investment, you spend 99% of your time assessing the merits of the opportunity and 1% thinking about whether what you see is real. The fraudster spends 100% of their time staying two steps ahead of you. Fraud is a risk you bear in every investment and sometimes you can’t avoid it.
This point has a strong ring of truth to it. A friend of mine who is a solid investor, once told me he was super-impressed with a company and its management after months of research and diligence. He ended up investing and made a decent return. However, a few months after exiting he found out the company, Valeant, was a fraud.
As investors we’re taught that we need to ‘turn over a lot of rocks’ in order to find investments. If you turn over enough rocks it seems, one of them will eventually have a landmine underneath it. We should do what we can to avoid those rocks but be fully aware that we might eventually get a few fingers blown off.
Thanks for reading and happy investing.
(PS I know I didn’t mention accounting techniques for discovering fraud. For more on that read the book “Financial Shenanigans” – it is excellent. Asian Century Stocks also made a presentation about simple techniques you can use to detect accounting issues - it can be found here)
Farrer Fun Fact
Cost of Energy: The above chart is taken from JPM 2023 Guide to Markets (read here). I’m not sure if the above accounts for subsidies, but it seems like renewables have become a real competitor in the future of energy.
Articles and Videos of the Week
Rob Vinall of RV Capital held his annual retreat in Switzerland a few weeks back. I was on a panel with other emerging fund managers where we discussed why and how we got started. Click here to view. Thank you to Rob for putting on a fantastic weekend of events!
If you want a succinct thesis on Google - read this investor letter (not investing advice, pls do your own research).
This thread about the importance of field research is excellent. That Druckenmiller anecdote about firing one of his money managers was a cold reminder to all in the industry - do your diligence!
A fun throwback about a Buffett interview in 1979. Its amazing how little his core thinking has changed over the decades.
This article about Standard Chartered’s history and the many attempts to sell the bank was fascinating.
As a further example, Buffett wasn't above falling for a fraud: https://www.theguardian.com/business/2020/may/19/german-company-allegedly-cons-warren-buffett-out-of-643m
The Cost of Energy chart you published this week could not be more misleading. It compares two intermittent sources of electricity, wind and solar, with thermal power sources coal, gas, and nuclear. The latter three run 24/7. Wind and solar-not so much! In fact, the chart would only be accurate if the wind blew and the sun shined constantly. When they don't, thermal plants carry the load and keep your lights on. If we transition to a grid solely powered by renewables, then whenever "night" and "calm" happen, we'll be living in the dark. Please don't fall for the fantasy of grid scale storage of renewable power. It doesn't exist, and won't due to the astronomical costs involved to bring it to scale.