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How can you tell a company is a fraud?

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February 03, 2011 – Comments (36) | RELATED TICKERS: CCME.DL

I have been reading through a lot of discussion boards about CCME being a fraud and it goes like this:

Longs: They are not a fraud, they have Deloitte

Shorts: So what, Enron Has Arthur Anderson, and SAY had PWC.  Any company can be a fraud with a top 4 accountant.

So, if any company can be a fraud, other than stuff listed in financial shenanigans, how can you tell if a company is grossly overstating its earnings?  It doesn't seem there is a way to tell, so it seems ridiculous to have such high convictions that a company is or is not a fraud.  How do I know Exxon isn't a fraud other than its sustainable dividend?  Etc.  Anything to look for besides the obvious?  If a company doesn't raise any red flags but reports a billion more in proft than it made, how can you know?

36 Comments – Post Your Own

#1) On February 03, 2011 at 6:44 PM, TheRuiner (71.70) wrote:

No body knows, that is why markets is just for gambling in rumors, in general a rumor is created for mark a clear trend for that reason is you choice gamble is better go with the tendency, here is downsize, so you gamble to the downsize until the tendency revert.

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#2) On February 03, 2011 at 6:56 PM, StoneyTerp12 (49.18) wrote:

First time posting, but as a CPA, I like answering these types of questions.  First and foremost, use the smell test.  If things dont smell right, they usually aren't.  Second, start thinking about where a company might conceal fraud, and half your battle is won.  If a company is overstating earnings, they can really only hide it a couple of places, namely accounts receivable, bad debt expense, and the infamous "other charges".  When you start seeing those three rising for no good reason, or you see percentage increases in A/R higher than sales increases, you should starting asking questions.  Last, pick apart the cash flow.  Its really hard to fake cash.  Would write more, and there obviously is more, but I'm in the middle of busy season.  Just remember, for every debit there is a credit.  So if one line item is wrong, something else has to be wrong too.  Hope this gets you started.

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#3) On February 03, 2011 at 7:37 PM, Valyooo (99.55) wrote:

Cool, thanks!  What do you see in CCME that's wrong?

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#4) On February 03, 2011 at 7:40 PM, Bays (30.22) wrote:

Sometimes you will just never know until it comes crashing down.

Think how many "experts" looked over Enron's financial reports and didn't catch it?

This is why it's incredibly important to diversify and NEVER have a holding represent anything more than I'd say 20%.

It's always a fun excercise to go read a company's financial reports after the cat's outta the bag.  Here's Enron's last annual report

But I do agree with Stoney above me.  It's very difficult to fake cash, and that is generally why investors love FCF and dividends.  

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#5) On February 03, 2011 at 8:05 PM, ETFsRule (99.94) wrote:

I'm long CCME and following the situation very closely. The shorts are primarily 3 guys, one of which has a past conviction for securities fraud (Andrew Left of Citron and formerly of StockLemon).

Muddy Waters is just 2 guys: Carson Block and Sean Regan. Not much of a track record there to speak of. They appear to have been right on RINO, but they were wrong on ONP. Actually they weren't "wrong" on ONP, they were lying about ONP to drive the price down.

Anyway, I see no reason to trust these 3 guys over Deloitte, the 2 analysts following the company, and the major shareholders including Starr who did their own due diligence.

So yes, the big four auditors aren't perfect. But these 3 individuals bashing CCME certainly aren't perfect either.

CCME is doing a great job of responding to the allegations and refuting the shorts. All of this can be found on SeekingAlpha, Yahoo, etc. It's an interesting drama, but it's not much fun when you're a shareholder.

To the original question, I guess you never know which companies are legit and which aren't. You have to look at all the evidence and see the big picture. In the end we are just playing the percentages.

One thing I do know is that home bias is a huge mistake and will cost you a lot of money. Think globally. Not all Chinese small-caps are frauds... in fact the percentage of frauds probably isn't much higher than it is for American small-caps. And there is a heck of a lot more upside for the Chinese ones... especially when they have a PE of 4, massive growth rate, etc.

Alright I'm done.

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#6) On February 03, 2011 at 8:57 PM, goldminingXpert (29.64) wrote:

ONP is still a zero, the stock is still circling the drain, not sure why you say Muddy Waters was wrong on that one ETFsRule.

To the original poster:  Stoneyterp's response is a good one. After you've analyzed enough companies, you start to realize what is normal and what just can't make sense. Why should CCME trade at such a low valuation compared to the real Chinese advertising firms such as Focus or Vision China? Why don't analysts cover CCME when lots of analysts cover their smaller competitors? If the company were real, the real professional investors would be interested in it. Just like SeaBridge, the fake gold company in Canada that claims to have a huge deposit but can't get a single reputable analyst to discuss it.

They real way to succeed at value investing is to find companies who are followed but disliked by the analyst community along with a catalyst they are missing. I started my long and successful campaign pushing Western Refining at 6 bucks because I saw potential while the analysts were screaming bankruptcy. (there was in fact a "$0.00" price target on WNR from one analyst when I said it was a screaming buy.) The reason WNR was a good deal was not because it is was an obscure company no one had heard of, but rather because it was a company that everyone thought was dead. I analyzed their business and debt and said, well, the analysts are wrong. Now WNR is at $14.

But in CCME (and many of these phantom Chinese NYSE-listed tout jobs), the numbers are so good because they are entirely fictional. No one audits them, no one calls their alleged customers, no one visits their "factories," no one can even speak Chinese who pumps these stocks. When an actual researcher visits (hello Citron), they find a fiasco and tell people the company is a fraud. Stock collapses, as it should. Short way to avoid danger -- don't buy stock in tiny companies who are ignored by analysts.

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#7) On February 03, 2011 at 9:40 PM, TMFBabo (100.00) wrote:

I just want to clear up one thing on the auditor. 

Having a top 4 auditor is a good thing and instills confidence in me that the likelihood of the company being a fraud is lower, as opposed to scam artist shops that help perpetrate frauds.  In fact, I like seeing top 4 auditors sign off on my companies' financial statements. 

However, it does NOT guarantee that a company is not a fraud.  It just means the company has a highly regarded auditor that is not known to purposely perpetrate fraud.  

Auditors simply check the financial statements to see that the correct principles were followed (US GAAP for US listed companies), assumptions and estimates appropriate, etc.  Numbers can be faked to jive with GAAP (generally accepted accounting principles) - cash cannot. 

Eventually, companies that fake the numbers will pay the piper when they start doing weird things like not paying suppliers or issuing equity way below market even though their balance sheets show tons of cash (it's obviously not there).

Each company's individual merits must be examined regardless of what auditor was chosen. 

In the Chinese reverse merger space, all companies start with a caution flag, since they were started via reverse mergers.  Add to that the risk of fraud allegations (whether or not they're true) and I say you have to demand much more attractive valuations and buy in baskets.  

I honestly believe there are a good number of undervalued businesses that were started via reverse mergers, but there are also frauds mixed in. 

I used to invest in these Chinese reverse shell merger plays, but I decided at some point that the 50 to 100 percent downside on EVERY single one of these things (due to true or false fraud allegations that could crop up at any moment) meant you had to demand quite extreme upsides (triples or quadruples) to have reward-to-risk ratios that made sense. I do not believe that every single one of these is a guaranteed triple, so I decided to walk away.  

I believe those that sniff out the good plays, buy in baskets, and do their homework (like living in China and visiting these companies) can make a lot of money investing in these things.  However, I've decided to do my gut a favor and stick to companies in the US and Canada.  

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#8) On February 03, 2011 at 9:43 PM, goldminingXpert (29.64) wrote:

Thanks, TMFBabo. Words of wisdom from one of the genuinely talented investors here at the Fool. I fully agree with your last paragraph:

"I believe those that sniff out the good plays, buy in baskets, and do their homework (like living in China and visiting these companies) can make a lot of money investing in these things.  However, I've decided to do my gut a favor and stick to companies in the US and Canada."

The coverse is true ... if you don't live in China and can't visit the companies, stay away.

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#9) On February 03, 2011 at 10:09 PM, Valyooo (99.55) wrote:

Babo,

Do you visit the oil and gas companies you invest in or do you just trust American companies more/ understand how american companies run better?

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#10) On February 03, 2011 at 10:47 PM, TMFBabo (100.00) wrote:

If someone called me out on one of my holdings and called it a fraud, I would want to hear every fact and either disprove him or sell the stock.  If I'm not able to disprove the claims, I could have a tough time holding on.  

I was careful not to mention CCME in my earlier post, because I'm currently undecided on them.  The problem is...I don't know companies in that space, I don't speak Chinese, and many other things. How can I argue against someone's fraud claims if I can't even search local news about the company?

What someone else argues is not good enough for me - I want to verify facts using company filings, press releases, investor presentations, conference call transcripts, and good ol' fashioned scuttlebutt (as Phil Fisher would say).  If I can't personally verify certain facts or disprove claims of fraud, I will not risk my hard-earned money.  

To answer your question: I don't visit the companies I buy (although I may from time to time in the future).  Corporate governance in America is much better compared to reverse shell merger Chinese companies despite some pathetic exceptions, I understand and speak English quite well, and there is simply a TON more information on them.  

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#11) On February 03, 2011 at 10:49 PM, TMFBabo (100.00) wrote:

I also want to add that fraud does not mean a company is going bankrupt - a company could simply be overstating earnings by a few percentage points and be correctly deemed fraudulent. 

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#12) On February 03, 2011 at 10:56 PM, JaysRage (90.16) wrote:

TMFBabo -- You have a very well articulated position and you've done a good job of putting the full argument on the table.    The due diligence that is necessary to invest in a company like CCME is extreme.    Even with all that due diligence, a day like today can make you want to throw up.   It's not for the lazy or the soft-stomach types.     

Auditors are not the end-all-be-all.  However, a top 4 auditor unable to pick up fraud in a company with a large cash position and good free cash flow would be hard to imagine. 

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#13) On February 03, 2011 at 11:02 PM, StoneyTerp12 (49.18) wrote:

Valyooo,

Please understand that I quite literally know nothing about this company and spent a grand total of about 3 minutes looking at the balance sheet, cash flow, and income statement.  When looking at the numbers, its vital to actually have background knowledge of the company to be able to put the numbers into context.  I have no such knowledge, so take the next piece with a grain of salt.  That said, two things pop out at me.  One, the dilution of equity.  They appear to have issued some stock for cash and then did nothing with the cash.  I'd want to understand that transaction thoroughly before moving forward, ie are they planning asset purchases, etc.  But, if they're just sitting on the cash, it would beg the question why?  Companies that are free cash flowing generally don't issue equity unless if they're planning to do something with it.  The second is the mysterious "other assets".  Things described as "other" always raise eyebrows.  There could be very plausible explanations for both had I actually read a little bit about them, but if I were thinking about investing, that's where I'd start looking.

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#14) On February 03, 2011 at 11:18 PM, Valyooo (99.55) wrote:

Jaysrage,

They are not a top 4 auditor...they are an Asian version of Deloitte, not the American one, from what I understand.

CCME means nothing to me as I hold no position, I was just talking in general terms.

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#15) On February 03, 2011 at 11:21 PM, Valyooo (99.55) wrote:

I don't understand this part of the argument....if a company calls a stock a fraud because they are short...don't you think it would make more sense that they shorted it BECAUSE they thought it was a fraud?

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#16) On February 03, 2011 at 11:53 PM, TMFBabo (100.00) wrote:

A lot of the people are just repeatedly saying Hank Starr invested his money, that they have a top 4 auditor, and all this other good stuff, thus they must be safe - they are missing the point BIG time.  They should be debunking Citron's arguments.  I applaud those that are attempting to defend their positions with valid arguments to try to disprove Citron's allegations.  I repeat: mentioning the top 4 auditor for the umpteenth time is not a valid rebuttal.  Anyway...

@Valyooo: I'm with you.  Before I summarily dismiss someone as having a conflict of interests, I want to hear his arguments. You don't know if he's a liar or if he has a great short thesis till you hear the man out.  

People bring up the conflict of interest side of things because the Chinese micro space unfortunately seems to be littered with liars who trash perfectly good stocks.  There are legitimate short-sellers as well, but the guys who trash stocks are illegally profiting off of statements that don't always jive.

I didn't catch all the Muddy Waters stuff, but that seemed really fishy to me.  Citron, on the other hand, I'd take a bit more seriously - right or wrong, they always bring up interesting arguments.  It would be unwise to dismiss them without first verifying whether any of the arguments check out.

@JaysRage: I saw your post on investing in Chinese micros - it was pretty good.  I'd say you have a process in place that will reduce (but not eliminate, of course) the risk of an implosion in your Chinese holdings. 

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#17) On February 03, 2011 at 11:58 PM, TMFBabo (100.00) wrote:

Yikes, it's Hank Greenberg of Starr Investments.  My bad on that slip up.

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#18) On February 04, 2011 at 12:04 AM, goldminingXpert (29.64) wrote:

TMFBabo: Muddy Waters is 2 for 2 so far. RINO was exposed as a complete sham within a month of their report, and ONP, their other research target, is continuing to fall toward a 52-week low after the company failed to convince the market that Muddy Waters was wrong. Of course, compared to Citron's illustrious 10-year record, Muddy Waters still has a long way to go. But that RINO call was pretty awesome.

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#19) On February 04, 2011 at 12:24 AM, TMFBabo (100.00) wrote:

@GMX: The fishy part was that they took their research down immediately on ONP, thus making it look like they were out to make a quick buck.  I wonder if that was due to an inadequate legal compliance process? I see now that I can get their stuff on both ONP and RINO.  I'll read it before calling them anything worse than "fishy" in the future.

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#20) On February 04, 2011 at 12:54 AM, goldminingXpert (29.64) wrote:

I believe ONP threatened them with a lawsuit, but that threat has passed and so the research is available again. They didn't originally have the disclaimer/click to get the report stuff, so I'm guessing you are correct in that it was a legal compliance issue.

I originally green-thumbed ONP after they came out originally with the reports, as I didn't find Muddy Waters to be credible. While I made points off that green thumb, post-RINO, MW's credibility with me has been much higher.

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#21) On February 04, 2011 at 8:32 AM, ETFsRule (99.94) wrote:

"Muddy Waters is 2 for 2 so far. RINO was exposed as a complete sham within a month of their report, and ONP, their other research target, is continuing to fall toward a 52-week low after the company failed to convince the market that Muddy Waters was wrong."

So they are 2 for 2 because ONP's stock is still down? That's an illogical conclusion.

Muddy Waters has not been able to prove any of their fraud allegations against ONP. It is just rumor-mongering which has hurt investor's confidence in the company. ONP has since hired Deloitte as well as another respected firm to go over their financials.

What more canyou realistically expect a company to do, in order to clear their name? I guess in your mind they are a fraud until the stock reaches new highs.

There is a story explaining how Muddy Waters tried to extort money from ONP, and they only wrote the negative report after ONP refused to pay them off. I'll post the link later today.

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#22) On February 04, 2011 at 12:07 PM, goldminingXpert (29.64) wrote:

Nah, ONP would be vindicated if they showed who there customers are, they proved their dilapated equipment actually worked, etc. Their business, from the video evidence taken by thestreet.com no less, is pathetic, and their diving stock price is indicative of that. Muddy hasn't commented on ONP in months, but ONP shares are falling hard again ... you can't blame shorts for your own bad business practices.

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#23) On February 04, 2011 at 12:24 PM, JaysRage (90.16) wrote:

@TMFBabo -- For me, nothing in the Citron piece was new, except their little piece about the Northern Securities analyst (which they claim to have called on a Sunday, by the way), and which resulted in a reaffirm by Northern the very next day, which pretty much puts their reputation completely on the line.    I've seen every single one of the Citron points in previous separate short articles written by someone else and I've seen every one of their points debunked.   It was literally just a short bashing synopsis piece.    Every single one of the points has been explained already, which is probably why longs that have done their due diligence are rolling their eyes and wondering why all this old garbage needs to be rebunked AGAIN, just because Citron pulled it off the trash heap.   I personally don't feel compelled to put the arguments together again, because it has been done better by other people, and I am more than comfortable with the explanations. 

Deloitte came in with Starr International.   It was a requirement of their purchase.   Call it Deloitte Jr. or whatever, but the fact that they came in together is good enough for me that their auditor is on the up-and-up.   In addition, their arrangement is not unusual of auditors setting up shop in foreign countries.

No one has explained the free cash flow and increasing cash position.   Where is all this cash coming from?

I agree that the dilution is a red flag, and it's probably the one biggest thing that bothers me about this entire company.   

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#24) On February 04, 2011 at 12:25 PM, ETFsRule (99.94) wrote:

Here is the quote from ONP regarding the extortion attempt, taken from here:

"Their actions of first requesting a substantial payment from
Orient Paper for positive coverage, and then establishing a short position and making libelous attacks on the company discredit their motivations."

More info can be found here. What happened was, the two analysts of Muddy Waters visited ONP along with another analyst named Rick Pearson. All 3 of them were very impressed with the company and found nothing wrong. Afterwards, Rick Pearson went long ONP and recommended the stock to others. Obviously he was stunned when MW later released their negative report.

One last thing to consider in the ONP case is that the auditors, including Deloitte, found absolutely nothing wrong. Even if you have your doubts about these auditors, this should still be enough to ease your mind. Why? Because this audit was done after the allegations were made against the company. The auditors knew exactly what they needed to look for, and they still found nothing wrong.

Here is where MW decided to wave the white flag on ONP and move onto other targets: http://seekingalpha.com/instablog/693516-michael-anderson/86184-muddy-waters-ends-their-battle-of-no-validity

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#25) On February 04, 2011 at 12:30 PM, goldminingXpert (29.64) wrote:

"Their actions of first requesting a substantial payment from
Orient Paper for positive coverage, and then establishing a short position and making libelous attacks on the company discredit their motivations."

If you tell a big enough lie... it's amazing how company's can get away with completely making crap up and otherwise smart people believe it. Rather than refute their claims, instead make up some wild Hollywood drama of conspiracy and intrigue. I like it, very theatrical! Still doesn't negate Muddy's accurate charges.

Oh, and Michael Anderson is a fool ... simply linking to him does you a disservice. All of Muddy's content on ONP is there again, now that the threat of a junk lawsuit from ONP is gone. Lawsuits stifle free speech, they don't fix rotten businesses.

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#26) On February 04, 2011 at 1:36 PM, StoneyTerp12 (49.18) wrote:

@JaysRage -- This is an in general comment, not specific to any companies being discussed, but it can be relatively easy to pump cash into a company through a related entity and use false contracts to call it "earnings".  In a ideal world, the auditors catch the use of false vendors and contracts, but that can be something that's difficult to spot depending upon how well the fraud is concealed.  The cash, in all likelihood, is very real.  Revenue can be fudged.

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#27) On February 04, 2011 at 4:07 PM, truthisntstupid (87.13) wrote:

http://seekingalpha.com/article/250498-china-mediaexpress-groundwork-research-and-videos-to-disprove-allegations?source=article_sb_popular_3

 

I do not know if Michael Anderson is  or is not a fool...since I don't really follow him and actually just scanned rather than carefully read this article.  I'm not that into doing hard time-consuming DD to support what is just a CAPS pick.

I also scanned many of the comments, and then did a search on Citron Research.   

 I've decided I don't like them.

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#28) On February 04, 2011 at 4:49 PM, goldminingXpert (29.64) wrote:

I'm sure you not liking them will make their long-illustrious track record go away. Just because you find them to be unsavory does not make their research wrong.

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#29) On February 04, 2011 at 4:56 PM, truthisntstupid (87.13) wrote:

No, but the article linked to provides more than enough information to cast doubt.   As do many.

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#30) On February 04, 2011 at 5:54 PM, goldminingXpert (29.64) wrote:

Michael has been shilling this scam for months, truthisntstupid. His "article" casts no doubt. There's much better defenses of CCME than this idiot.

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#31) On February 04, 2011 at 5:57 PM, goldminingXpert (29.64) wrote:

Here's Mike touting the company up over 20.

http://seekingalpha.com/article/249009-more-stocks-that-will-enhance-your-portfolio?source=qp_article

He'll still be touting it when it hits the single digits.  Just because someone is posted on SeekingAlpha doesn't make their opinion valid.

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#32) On February 04, 2011 at 6:11 PM, truthisntstupid (87.13) wrote:

Why is he an idiot?  I don't care one way or the other, and wouldn't put real money in China for the same reasons TMFBabo gives.  But none of the arguments he makes in that article have any validity?   Why?

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#33) On February 04, 2011 at 6:13 PM, TheFoolishEdge (23.31) wrote:

For less established companies I would check out www.sec.gov and review all the information.  Look at the structure of the company and see if there are any indication of a pump and dump scheme.

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#34) On February 04, 2011 at 6:19 PM, goldminingXpert (29.64) wrote:

Read his articles. He has a price target of over $1,000 on AAPL. His articles are superficial and lack any specifics. He takes other people's word at face value without doing Due Diligence. He concluded back in January that CCME was legit because Hank Greenberg (a terrible investor) and Northland Securities (who?) liked the company. It goes on. Read his stuff, and you'll know why I said what I did.

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#35) On February 04, 2011 at 7:04 PM, ETFsRule (99.94) wrote:

Well GMX, you're on the record calling CCME a "scam". Obviously nothing is going to change your mind right now, but lawsuits are being filed by both sides, and CCME will report their earnings in a few weeks. The truth will be revealed soon enough.

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#36) On February 04, 2011 at 9:01 PM, goldminingXpert (29.64) wrote:

That's a good place to leave the discussion for now ETFsRule. Place your bets (in my case red thumb, no cash involved) and see what happens. Best of luck with your investments!

GMX

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