Editor's note: This weekend, we're taking a break from our regular fare to share an essay from business colleague Joel Litman. In this essay, adapted from his Altimetry Daily Authority newsletter, he discusses stock market fraud – how to sniff it out and how to protect yourself from it – and shows how a company's credibility goes beyond its financials...
In late 2010, one of our largest clients called us in a panic...
One of its biggest holdings, coffee maker Green Mountain Coffee, had just received a data request from the U.S. Securities and Exchange Commission ("SEC") stating it was launching a formal investigation into the company's accounting.
Our client needed to know what to do... immediately. If the company was fraudulent, the stock could drop to zero – potentially wiping the fund out alongside other shareholders. But if Green Mountain's accounting was clean, the stock could experience a massive rally.
So my team and I went to work.
It's a poorly kept secret that most people on Wall Street have no idea how to analyze financial statements...
Most of the high-powered hedge-fund portfolio managers, analysts, or private-equity managing directors don't come from an accounting background.
They generally have experience in investment banking or consulting. Their job is to know the companies, the people, the players, and the industry inside and out.
Others are quantitative analysts – math pros who can bend numbers to yield the insights they're looking for. But most of these folks don't know the difference between earnings before interest, taxes, depreciation, and amortization ("EBITDA")... net working capital... or deferred revenue. It isn't what they're paid to do.
When accounting questions come up, the reaction is, "It's all Greek to me." That's why nine of the top 10 biggest money managers on the planet call up my team and me to help.
Back when I was an accountant, I was fortunate enough to study under two mentors who were literally the auditors to the auditors. They both were the authors of the GAAP Guide – what many consider the "bible of accounting."
They helped teach me how to analyze the financial statements... but most important, how to analyze the people behind the financial statements.
So when we built our team of analysts in Manila, Philippines, we went out of our way to fill our staff with accountants – CPAs, or folks on track to become CPAs – who would understand not just what the financials were saying, but the background of the financials.
As such, our team is great at identifying when management may be playing games with the accounting – or finding "financial red flags," as we call them.
And just as important, we're able to determine when management is being falsely accused.
While we have a strong accounting background, it's not just our team's understanding of the numbers that helps us identify questionable activity from management.
The truth is, finding management who plays games with the numbers doesn't often start or end with the accounting...
If you want to find companies that might have red flags, don't start by analyzing the numbers... Start by analyzing the people.
That means looking at who the auditors are, what management's background and history is, how management is compensated, and analyzing management's communication.
In the case of Green Mountain, the SEC was concerned that the company artificially inflated revenue by having a distributor take on inventory and then recognizing it as revenue when it wasn't really sold yet. So we started by first analyzing Green Mountain's partners...
The SEC worried about Green Mountain's brand-new partner, M. Block & Sons. The distributor went from nothing to 51% of Green Mountain's receivables... That type of explosive growth in non-cash revenue is a meaningful signal that management might be artificially boosting revenue.
We immediately researched M. Block and found it was an independent distribution business that various vendors across the globe had used for years. M. Block had no reason to help Green Mountain artificially boost its earnings.
We also analyzed Green Mountain management's earnings calls. Executives weren't showing any signs of deception when talking about the distribution growth with M. Block.
Before even looking at the accounting, we already knew fraud was unlikely. We knew to audit the people behind the accounting – and everything came up clean.
Asking the right questions helped us conclude that Green Mountain was in the clear. Our client stayed in and made a massive profit as the stock bounced back... and as Green Mountain's stock rose higher when its Keurig coffee system took off.
On the other hand, our analysis has also turned up some of the biggest red flags you could imagine...
In early 2011, snack maker Diamond Foods announced that it planned to acquire Pringles from Procter & Gamble (PG) for $1.5 billion in stock. At the time, one of our clients who was considering buying in approached us for help.
Our client had heard concerning rumors about Diamond's accounting for its payments to walnut growers. Additionally, the cost savings that the company was telling Wall Street it could generate from the merger looked suspiciously low... like Diamond was artificially understating how much savings it thought it could generate.
Our team got to work analyzing the people...
We found that Diamond had significant leverage on the books from a prior acquisition spree. Key covenants in Diamond's debt required it to keep earnings high, so as to not get on the wrong side of debtors.
On top of that, the company had targeted an all-stock acquisition of Pringles. To convince Procter & Gamble that giving its investors Diamond stock was a good idea, the company needed to show strong and growing net income.
Those facts helped explain why management might have knowingly manipulated Diamond's accounting. As we said, to identify fraud, you need to find a management team who has reason to play games.
Then, we found the most damning piece of evidence...
When we analyzed management's calls about the Pringles merger, our "Earnings Call Forensics" process generated signals that suggested they were hiding something.
Remember, Diamond Foods was rumored to be "sandbagging" its potential savings from the Pringles acquisition – understating expectations so it could post better-than-expected results. And on the earnings call, management's comments appeared to confirm exactly that.
It's far too easy for a motivated management team to commit fraud and hide it from less-aggressive auditors. It can go on for some time... That's why fraud often only becomes apparent when companies want to bring the financial statements back to reality.
Management tries to start reporting what the company is really doing. This sets off a big swing in the numbers that triggers warning bells for investors, auditors, and anyone else paying even a little attention.
Diamond's management wanted to wrap up the games it was playing with the accounting. It wanted to clean up how it reported its walnut growers' payments. And its solution for hiding that cleanup started and ended with Pringles.
The company would use the Pringles acquisition to cover up its previous shady accounting.
Fortunately, we told our client to stay away from the investment. Diamond couldn't keep up the façade... And eventually, other people caught on to the same issue that we had identified months earlier. Making matters worse, the walnut growers started getting more vocal about being underpaid.
And then, everything unraveled...
Diamond had to delay the closing of its Pringles acquisition. Procter & Gamble got cold feet and pulled out of the deal.
The SEC started to investigate the payments and found that management played games with the timing and size of its payments to the walnut growers.
The stock fell from more than $79 per share in September 2011 to less than $14 per share by late 2012. More than $56 million in earnings came out of the company's financials... and Diamond Foods had to pay $5 million in fines to the SEC. Tragically, the story ended with one of the directors taking his own life when he realized the repercussions of what the company had done.
We saw it all before the company's stock completely collapsed because we weren't just paying attention to the accounting... We were focusing on all the people and factors that lead to the accounting. We were looking at fundamental forensics.
Today, we're using this analysis in a part of the market where it's most needed...
It's an under-the-radar space that our big institutional clients have never been willing to pay attention to.
For every big-cap Green Mountain Coffee or Diamond Foods that may (or may not) be engaging in questionable activities, there are dozens of the tiniest stocks in the market – microcaps.
Institutional investors, journalists, and the SEC all police the biggest companies in the stock market heavily. These companies can rarely do something questionable because so many eyes are on them.
But in the microcap world, the same level of supervision doesn't exist. And because of that, many investors are afraid of these stocks.
That's why we've decided to launch a brand-new product to put those concerns to rest. In Microcap Confidential, we analyze the tiny companies that no one else is monitoring.
First, we identify the businesses that are set up like Diamond Foods – companies where management teams are out for themselves and not looking out for shareholders... and where we see other red flags that suggest the stocks could go to zero.
If we can do that successfully, then we can identify the businesses that aren't playing games – the tiny companies that have massive, 1,000% upside.
Many of these companies have huge tailwinds at their backs. And since microcaps start so small, they don't need to do a lot for their stocks to rocket higher.
You'll rest easy, owning these tiny, unfollowed names – while knowing we've done the same investigatory work we did for Green Mountain, Diamond Foods, and others. We're doing our due diligence to find the safest stocks with the biggest upside.
To learn more about Microcap Confidential – and how to gain access to the seven microcaps primed for big gains ahead – click here.
Editor's note: Joel believes microcap stocks will be the biggest moneymaking opportunity of the next 50 years. He has used his "stock forensics" to identify seven tiny companies destined to rocket as much as 1,000% from here... Click here to learn more.