How I Spotted a Fraud (Before It Was Too Late)
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I couldn’t fall asleep. As I was tossing in bed, I felt that I almost had it figured out. Figured out what was wrong with the company that I had recommended that the investment firm that I had worked for invest tens of millions of dollars in. That was before my mind started to put the pieces together and warn me that something wasn’t quite right. And then I had it: the management team was manipulating earnings to make them seem much larger than they really were, and I had just figured out exactly how they were doing it.
January 2002
I had started as a young equity analyst at one of the largest mutual fund firms in the world right after getting my undergraduate degrees in Economics and Computer Science from MIT. And now, 6 months later, I was asked to decide whether we should invest tens of millions of dollars on a secondary stock offering by one of the companies in my coverage, a specialty chemical company called OM Group.
At first I thought there must have been some mistake – why would veteran portfolio managers, senior investment officers of the firm, want the opinion of a 22 year-old kid who couldn’t possibly know all that much about investing? But no, I was told this wasn’t a mistake. This was how the firm operated – my coverage, therefore my recommendation decision.
Across the table from me sat a tall, well dressed CEO by the name of Jim. His face turning red with excitement, he was espousing the benefits of cobalt-based specialty chemicals. These weren’t commodities according to him, but rather special, niche products with a lot of material science technology in them that only few companies could produce.
“Speaking of cobalt,” I ventured, “where do you get that stuff anyway?”
Jim was prepared. With sweat glistening along his receding hairline, he patiently explained that cobalt wasn’t mined directly, unlike, say, copper. It was a by-product of mining for other metals. And the biggest source was in the Democratic Republic of Congo.
At this point, a veteran portfolio manager interjected with a question: “Is that an independent country?” There was some nervous laughter around the table, but since neither Jim nor I were sure if the question was serious or asked in jest, he promptly assured us that it was indeed quite independent.
Apparently, in some ways it was a bit too independent. The cobalt was stored in piles in open areas around the mines, the biggest of which was descriptively called The Big Hill. Given some of the armed gang/rebel activity in the area and the limited reliance Western companies could have on government protection, part of the cost structure was paying for some “supplemental protection.” I swallowed a bit nervously, but the meeting continued.
Eager to demonstrate my knowledge of the financial statements to the CEO and the portfolio managers in the meeting, I asked Jim why, despite plenty of earnings growth, the company has not produced much free cash flow over the years. Jim casually brushed off my question. The company was investing for growth. Besides, it will be different this time, plenty of cash flow in the future, he said.
I asked him if we could hold him to that. Speaking as if it were a done deal, he firmly said “Of course!” and extended his hand with a broad smile on his face. I still didn’t quite understand what would be different in the future to make the company suddenly produce copious amounts of free cash flow to match its reported earnings, but we were out of time and the meeting was at an end.
After Jim left, I went to my cube to crunch the numbers and do some thinking. I had this nagging feeling that somehow the absence of free cash flow was an important red flag. Nah, I thought. Perhaps I am still learning about how such companies are supposed to work. Besides, didn’t Jim and I shake on it? The stock was inexpensive based on the company’s earnings, so I decided to recommend that we buy more stock as part of the secondary offering.
Dinner at the German Castle
Later that year, OM Group decided to host its investor day in Frankfurt, Germany. It was a blast. As a recent college grad with a net worth close to zero, European travel was not typically in my budget. And here was an excellent (and legitimate!) opportunity to see another country and learn more about the company that I recommended we invest in.
The night before the investor presentations, institutional investors like myself were entertained by company management at a magnificent dinner. The restaurant was in what once used to be a large castle. To create an authentic atmosphere the theme was also quite medieval – plenty of meat and only a single, giant knife for a utensil. Not having covered such a scenario in my one-day “charm school” workshop at MIT, I did my best to avoid wearing a good chunk of my dinner.
During appetizers I had a chance to chat with the CFO while enjoying our finger-food at a cocktail table. Interested in getting a better understanding of the financials, I started to pepper him with some numbers questions. He didn’t bite, and deftly deflected my attempts to pin him down.
Deciding that perhaps all the numbers will be revealed during the next day’s presentations, I decided to back off and ask him how he and his family were doing. He smiled and volunteered that they had just bought a new home in Florida that he was quite looking forward to enjoying. I decided it would be impolite to ask him what attracted him to Florida given that the company wasn’t doing any business in the state, so I decided to just relax and enjoy the evening.
The following day was a disappointment. The investment presentations were full of stories and descriptions of the exciting products that the company was working on. It was hard to believe our fortune as investors – according to management, it was positioned squarely in the middle of multiple secular tailwinds. Naively waiting for some specifics and financial details, I was left quite unsatisfied. Unfortunately besides stories, glossy pictures and rosy projections the company wasn’t planning on providing us with any numbers to back any of that up.
Accounting Chicanery: The Big Hill
Back in Boston, I was eagerly anticipating the company’s earnings report. The company delivered spectacular earnings growth and raised its guidance for future earnings. This was an analyst’s dream. The stock went up.
Only I didn’t feel particularly great. One thing was missing, again. Free cash flow. I decided to call the CFO, and as a representative of a large investor got him on the phone right after the earnings conference call ended. I decided it was time to get past the stories, so I started out quite directly, by asking him what happened to the free cash flow and how we could reconcile this with Jim’s promise to us during the secondary offering roadshow.
The CFO was clearly irritated by my question. Wasn’t it enough for me that they beat Wall Street analysts’ earnings estimates? That they raised their guidance? That the stock went up? And all I wanted to talk about was this pesky free cash flow? He didn’t quite come out and say it that way, but the message was clear in his tone of voice as he dryly informed me that cash flow takes time and that they are still quite committed to delivering it for the full year.
The investment firm that I worked for operated by analysts making the rounds to call on the portfolio managers. The latter held each analyst’s fate in their collective hands, deciding who would get promoted and receive more lucrative research coverage and who would be stuck covering industries like chemicals forever (or worse). They were also the firm’s experienced investors, having been analysts for many years themselves prior to assuming the responsibilities of managing clients’ money.
As I made my rounds, one veteran portfolio manager wanted to catch up about OM Group. I told him about the supposedly great results and my concerns about the lack of free cash flow. He started paying more attention to me, his posture still relaxed. He inquired about how the investor day went. I answered that I didn’t learn much, other than that the CFO had just bought a large new house in Florida.
The portfolio manager’s smile and relaxed posture immediately disappeared. With a furrowed brow he asked me to confirm: in Florida? Yes, in Florida. Why, was that a particularly poor state to purchase a house in?
His reply sent shivers down my spine, “Don’t you know that in Florida they can’t take away your primary residence, even if you go to jail for fraud? Start digging through the company’s financial filings immediately.” I left in a hurry and pulled up the annual form 10-K where each U.S. company files its financials with the SEC and began reading it again.
I decided to start by figuring out where was all the free cash flow going. When a company reports earnings on the income statement, the idea is that over a period of time they are supposed to represent free cash flow. Sure, there can be temporary timing differences that would account for why earnings can be higher or lower than free cash flow. However, over a number of years, unless the company needed to invest heavily to support its growth, the two shouldn’t be very far apart.
It didn’t take me long to find out what accounted for most of the gap between earnings and free cash flow. It was inventories. I pulled up the footnote describing inventories. The portion that seemed to be growing and consuming all the cash was the raw materials line. Interesting.
It was getting late and I was travelling to see the management team of OM Group the next day on a trip arranged by a Wall Street analyst for a group of institutional investors. I decided to go home and sleep on it. Perhaps after getting some rest I would be able to figure out the final piece of the puzzle.
Confronting the Management
Ten of us filed into a large conference room with cushy black chairs. The Morgan Stanley analyst who was organizing the meeting told us that the agenda was for us to spend an hour with the CFO and then another hour with the CEO. Despite being by far the youngest in the group I decided to kick off the question session with the CFO.
I was 99% sure I had figured out how the management was manipulating their earnings to appear much bigger than they really were. But then again, this was my first year as an analyst. What about that other 1%? What if I were wrong and embarrassed myself in front of many of my peers from other firms? I decided to build up the argument, as a lawyer would in court, rather than just come out and accuse the CFO.
I started gently. “So how are cobalt prices behaving lately?” An innocent question that could be asked for many potential reasons, so not one likely to arouse much suspicion.
The CFO, quite relaxed and smiling, quickly answered “They have been falling for the past year, quite a bit.”
Of course, I had already known the answer, so I proceeded on to the next step in the argument. “Can you remind me, are you on LIFO (last in, first out) or FIFO (first in, first out) inventory accounting standard?” When a company is on LIFO, the cost of the last batch of raw materials that it buys gets expensed on the income statement immediately, while as the inventory on the balance sheet is priced at older purchase prices. Conversely, a company that is on FIFO would have the old raw materials prices expensed in the current period and the inventory on the balance sheet would be reflective of the prices at which more recent purchases were made.
The CFO lost his smile. “We are on LIFO.” I had already known that as well.
“Have you been buying more cobalt than you have been using in your production, with the remainder going to inventory?” I asked. The CFO was now clearly tense. He nodded. “Yes, we have been. We really like these lower prices and wanted to stock up.”
The time had come for the final piece of the puzzle. As I started to ask my next question, the CFO lost his friendly demeanor and objected. “You have asked enough questions, give someone else a chance to ask some next.” Normally he would be exactly right, and I would not dream of monopolizing a large group meeting. But this wasn’t a normal meeting. I needed to finish making my case before he was able to divert attention to something else.
Luckily, Frank, a grizzled industry veteran, interjected. “Actually, we would like you to keep answering Gary’s questions. Go on.” The rest of the analysts nodded. It was time.
“So if I understand things correctly, if you weren’t buying so much cobalt you would be forced to use the older, higher-cost, cobalt from your inventory in calculating your Cost of Goods Sold. If that were the case, your reported earnings would be much lower than they have been. The only way you can produce these higher earnings that you promised to Wall Street is by using up all your free cash flow to buy the lower priced cobalt so that you can use these lower prices to lower your reported expenses and boost your reported earnings. If you were to actually generate the free cash flow, most of your earnings would evaporate since accounting would force you to use the older, much more expensive, cobalt sitting in your inventory. Does that sound about right?”
The CFO’s face turned bright red. The T. Rowe Price analyst sitting next to me got up from the conference room table and excused himself to make a phone call. The meeting was over.
Conclusion
Before I even made it back to Boston, I sent out a research note to all of the portfolio managers changing my recommendation on OM Group from a “buy” to a “sell.” As soon as I landed I made the rounds and implored everyone to sell given that it was clear to me that the company’s reported profits, the main reason for my recommendation, were grossly over-stated. They listened.
We exited our investment at only a minor loss of less than 5%. Within a few months, the stock, which had recently traded around $70 per share, fell to a low of $4. Fortunately, we were watching from the sidelines by that time.
A couple of months later I received the “high achiever award” for the best sell rating on a stock. It came with a nice $15K check, which was a lot of money. I wasn’t sure that I deserved it. I got us into this mess and had it not been for my skeptical nature and attention to detail, we could have lost our investors tens of millions of dollars.
The Lessons:
There is a reason why experience is so important in investing. You don’t want to make all the possible mistakes yourself in order to learn, which is why I am sharing mine with you. Keep the following in mind to help steer you away from trouble in investing:
Be highly suspicious of companies that have free cash flow that is significantly below earnings for a long period of time. Unless the company is making verifiable investments likely to produce attractive returns, you are better off passing.
Don’t believe what managements tell you they will do. Instead, rely on what they have done.
Be wary of companies that are all story and no numbers. If the story is so great, shouldn’t there be plenty of numbers to back it up?
Read financial statements carefully. No, it’s not always fun. But if you are going to be a serious investor and think that you are too busy to carefully read the footnotes, watch out. You might be setting yourself up for a big loss. If it turns out that you could have caught it by studying the financials carefully, you will have nobody but yourself to blame.
The price of the investment always matters. I was so busy celebrating my good call to exit shares of OM Group at $70 before the collapse that I never seriously re-assessed the investment at the new price of $4. That was a mistake – the stock eventually went up 10x from those levels. Keep your mind flexible and keep re-evaluating investments as the circumstances and the prices change.
If you are interested in learning more about the investment process at Silver Ring Value Partners, you can request an Owner’s Manual here.
If you want to watch educational videos that can help you make better investing decisions using the principles of value investing and behavioral finance, check out my YouTube channel where I regularly post new content
Note: An earlier version of this article was published on Forbes.com
