Here are a few tricks that I use to spot fraud, especially in riskier emerging markets such as India, China, Vietnam or Indonesia.
Going through the list doesn’t take a lot of time and will quickly give you a sense of whether a company is telling the truth in its accounts.
The companies mentioned below are not necessarily frauds. I am just highlighting them to make a point about what specific red flags you should look out for.
1. Excessive operating margins
Plot the operating margins of the company vs other companies globally employing the same business model.
Ask management why their margins are so much higher than those of their global peers. Does their explanation make sense in light of the company’s comparative advantages and bargaining power within the supply chain?
Are depreciation policies more aggressive than those of their peers? Are they capitalising software or R&D expenses? The footnotes in the annual report will tell you this. Just press Ctrl + F and search for these specific keywords.
If you’re not satisfied with the answer, then check the company’s related party transactions in the annual report and see what percentage of sales and COGS are with associated companies. They might be shifting costs to these related parties. For example, the parent company or another company run by the founder.
2. Cash flow lower than net profit
If cash flow from operations is consistently lower than the sum of (net profit + depreciation and amortisation), then something might be off. A certain item must be sucking up cash: working capital, non-cash gains & losses or capitalisation of R&D, for example.
Identify the specific item that explains the weak cash flow generation. Is this source of profit likely to lead to cash generation in the future?
3. High accounts receivables
High accounts receivable days (accounts receivables / revenues * 365) compared to peers suggests the company is not getting paid by its customers. If a large portion of accounts receivables are long-term in nature, then company is really not getting paid.
You can find this information easily from the latest yearly income statement and the latest balance sheet.
Further, if the accounts receivable balance is growing faster than revenue, then it means that the company has loosened its credit standards to manufacture top-line growth. Or the company might be recognising revenue prematurely.
Review the “Revenue recognition” section in “Significant accounting policies” section of the financial statements. This section will explain how and when revenue is recognised. Does their revenue recognition meet the typical four criteria that companies should abide by? Or is revenue recorded before delivery has occurred and before the customer has committed to paying?
Try to identify the customer who isn’t paying. Is it a major distributor who is connected to the controlling shareholder? Bloomberg’s SPLC function may help identify major customers or suppliers. The annual report will typically also tell you who the company’s major customers are, and sometimes also name major distributors.
4. High inventories
Inventory days is calculated as (inventory / COGS * 365). See if the inventory turnover is significantly higher than those of its global peers.
Also check to see whether inventory is rising faster than COGS (cost of goods sold).
If the company is piling up inventory, it might mean that demand is weaker than expected. Or the company is manipulating earnings by inflating end-of-period inventory levels, thereby lowering period COGS and overstating profits.
5. Low effective tax rate
If tax expense / pretax income is lower than the statutory corporate tax rate, ask management why the company isn’t paying tax. Are they enjoying special tax incentives? Or is the company’s taxable income (as assessed by the tax authorities) much lower than the profits they are reporting to foreign shareholders?
Tax expense and pre-tax income are both found in the income statement. Double-check with tax actually paid in the cash flow statement. There is typically also a footnote providing details about the company’s tax liabilities.
6. Excessive M&A
Large amount of goodwill means that the company is acquiring many companies at high prices. If the amount of goodwill > shareholder’s equity on the balance sheet, then M&A must be playing a central role in the company’s business model.
Look at the company’s ROE (return on equity = net profit/shareholders equity) or ROIC (operating profit/invested capital). If it’s been trending lower to say a single-digit range due to M&A, then those acquisitions probably haven’t been very successful.
If the acquisitions represent R&D needed to maintain unit volumes, then they are essentially “outsourcing R&D” and the acquisitions should be deducted from profit to calculate long-term sustainable earnings.
If one of the acquired companies remains listed and the share price has dropped far below the purchase price, see whether the company has written down any of the goodwill pertaining to that acquisition. The footnotes in the annual report will usually tell you this. Companies refusing to write down goodwill of failed acquisitions are over-stating their earnings.
7. Key metrics on a per-unit basis
Break down the business into its key building blocks and compare the accounting data to those building blocks.
Does the company have enough property, plant & equipment (PP&E) to produce a given amount of revenue?
Does the company have enough PP&E for a given unit of a business (say per available hotel room, or per employee)?
How does revenue/employee compare to peers - are the company’s employees unusually (suspiciously) productive?
If these numbers don’t add up, then the company might be lying about the number of employees or the number of hotel rooms controlled by the company. The next step will then be to dig into their parent or sister companies and whether costs might have been shifted to those separate entities.
8. High corporate bond yield
Bondholders often see through games that fraudulent companies play, including hiding debt in JV structures or unwarranted capitalisation of expenses. Bloomberg DDIS shows you bond pricing data, as do free websites such as Bondsupermart.com or Cbonds.com. Look at the company’s outstanding longer-dated bonds and then compare the yield-to-maturity to the company’s peer group. If you have access to a Bloomberg terminal, plot the yield historically with Bloomberg GY.
Bonds yielding 3-6% suggest strong creditworthiness. Bonds yielding 7%+ suggest a real risk that the company is not healthy and might enter a debt spiral. A rising bond yield is cause for concern, suggesting that the company’s creditworthiness is on a deteriorating trajectory.
9. Low interest income from cash
In China, bank statements are often faked. You can’t trust that the cash is actually there.
Take interest received in the cash flow statement. Divide by average cash and cash equivalents on the balance sheet over the past two end-of-year reporting dates. Figure out in what currency the cash is being held. If the effective interest rate received on the cash is far below typical deposit rates in that country, then the cash might not be real. Or just transferred to the ListCo on the balance sheet date and then back again. Ask management. If they’re unable to give you a good explanation, you should probably assume something is off.
10. Rising share count
If you own shares in a particular company, you presumably think that those shares are undervalued. And if you think the shares are undervalued, you wouldn’t want your existing stake to be diluted by the company issuing shares below intrinsic value.
Building company empires can help maximise management team’s salaries, influence and prestige. And issuing new shares to acquire other companies or expand will help build such an empire.
Instead of tracking individual share issues and buybacks, look at a 20-year chart of the company’s shares outstanding. Bloomberg GF or TIKR plot the chart in a matter of seconds. Flat or declining share count is great. A consistently rising share count probably means that the company is not working in the interests of minority shareholders.
Going through the above ten steps will take you less than an hour for each stock. Time well spent if you’re investing in riskier emerging markets such as China or India, in my view. I think the real deal-breaker is having a company’s corporate bonds yield more than 10%. Persistent cash drain also disqualifies a company from an investment, in my view.
If you would like to support me and get 20x high-quality Asian investment ideas per year, thematic reports and catalyst-specific ideas, try out the Asian Century Stocks subscription service - for the price of a few weekly cappuccinos. Check out my previous ideas here.