value and opportunity

Over the last few weeks, I discussed the Globo Plc case quite extensively with other investors. I think many people were attracted to it because it looked so cheap despite having a “sexy business”. Sometimes I was succesful in my efforts to talk people out of it, sometimes not.

And just to be clear: I don’t think that investors who owned Globo shares are stupid. As it seems for now, Globo has been a “pretty well-managed” fraud with a true core and very good actors as management. Everyone makes mistakes and the only sin is not to learn from them for the future.

What I found interesting is that some arguments in my discussions tend to show up almost each and every time in those situations, for instance also in the German-Chinese fraud cases I had written about. Most of the arguments circle around certain facts that because x, y or z is involved it cannot be a fraud, which often turns out to be not the case. So without wanting to insult anyone who I talked to or trying to be the “head teacher”, I just wanted to list some of the arguments I encountered multiple times in those discussions. Maybe they help in the next case, maybe not.

1. Famous investor xyz has a big position in the stock and they are well-known for in-depth due diligence and direct contact to managemnt

Everyone makes mistakes, even the most famous investors. Don’t outsource your due diligence to famous investors. You never know if the “famous investor” has deeply looked into the stock or just a (soon to be fired) junior associate.

2. I have actually talked to famous investor xyz with the big position about that stock and they seem to be really sure about it

Well, what would you expect if you talk to an investor who has a large position ? Will he tell you “I am not sure anymore and I will start selling next week” ? Most probably not. This is the famous “Don’t ask the barber if you need a haircut” situation. In situations like this it is much more helpful to talk with investors who don’t own the stock or who are even short. Everything else is just playing into the “Confirmation Bias” behaviour.

3. But they have an (well-known) audit company who checks the accounts

Many investors seem not to be aware what auditors actually do. Auditors are not responsible to uncover fraud. They are only responsible for checking the documents provided by the company for consistency. It is not the responsibility of the auditors to detect a “consistent fraud”. Don’t outsource due diligence to auditors, they don’t work for investors, only for the management of the company. Auditors get paid for the fees they generate, not for being right or wrong.

4. Reputable bank ABC has lent them money. They would not do this if there would be something wrong

Well, if this would be a general rule, we would have not had a financial crisis. In Globo’s case, significant “upfront fees” were involved with the loans. Anyone who has contacts with banks knows that once there are “juicy fees”, lending standards often become secondary. In most of the German-Chinese frauds, reputable banks extended loans as well. As with the famous investors, don’t outsource your research to others especially not banks !!

5. Reputable bank ABC has a “buy” rating on the stock

Sell side research is really the least reliable source of true information in capital markets. Most of the research is still driven by a desire to get business and most sell side researchers who are really good don’t work there very long.

6. I have spoken to management directly and they explained me this and that. They were really nice guys.

My experience is the following: If you really have large-scale fraud, the people running the scheme are often brilliant and charismatic. Otherwise they would have been detected much earlier. Direct involvement with those persons often doesn’t help, in contrast, one gets entangled by their “charisma” and accepts things which are simply not acceptable seen from a distance. Bernie Madoff seems to have been a very charming guy when you met him privately. The longer the fraud works, the more confident people get. I have read lot of books on frauds and in quite a lot of cases, the fraudsters at some point started to believe their own lies which made them even more convincing. At remember: As with driving a car, on average we are only average judges of people and character.

7. I have spoken to management and they gave me additional reassuring info which is not in the official reports

Well, this is a big RED FLAG. Management disclosing material non-public info to investors in “one-on-ones” is in my opinion a big problem. Any reputable management would never do this. As the recipient of this information, you feel privileged but on the other side: If they cheat the other investors by selectively disclosing stuff to you, then it is not a big step to cheat everyone.

8. They account aggressively because everyone in Tech does it

Well, no. Not everyone accounts aggressively, even within tech. As a value investor, the trick is to find those who run their business conservatively and stay away from aggressive ones.

9. It can’t be a fraud. I have seen the product, it is for real

Many frauds have a “real” core. Enron had some divisions which made money, even Bernie Madoff ran a “real” brokerage business as a front. Rarely, everything is totally made up. The question is not “do they have a real product” but “Do they have real sales and real profits”.

10. The company is so cheap, even when this one thing turns out to be fraud, the stock is still a bargain

Charlie Munger said something like this: “Cockroaches rarely travel alone”. Which means if there is one big problem that you can see, there are often many more problems that you don’t see. Once there is serious doubt with regard to integrity of the management, there is no margin of safety anymore.

11. They are financially unsophisticated, that’s why they did this and that one normally wouldn’t do

In Globo’s case it was the super-expensive loan and the potential bond, in the Chinese cases it was why they were selling new shares at a P/E of 4 or lower. When it comes to loans and new shares, one can be pretty sure that management is quite sophisticated. Especially when a company does a lot of M&A, uses a complex structure to avoid taxes and claims to do things like cash pooling, then unsophistication is a pretty unprobable explanation for strange and unlogical things. Underestimating the sophistication of a potential fraudster is not very sophisticated from an investor’s perspective.

Summary:

Most of the prinicipal issues which I see in cases like Globo can be summarized in 3 major points:

1. Don’t outsource due dilligence to 3rd parties (auditors, banks, other investors)
2. Don’t believe in what management says, especially when it is on a “privileged” basis.
3. Don’t underestimate potential fraudsters.

The best strategy to hopefully avoid such cases in my opinion is to fight the Confirmation Bias and search for opposing opinions wherever you can find them.