Tag Archives: Fraud

Globo – lessons learned: Don’t outsource your research

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.


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.

Updates: MIFA & Nuclear decommissioning liabilities

Just a few quick comments on events that caught my eye while I was on vacation:


As predicted in my post some weeks ago, the troubles of MIFA were clearly not a temporary 2013 “accounting system” issue but a result of dubious inventory accounting over multiple years (or simply stated – fraud):

This is the quote from the news release last week:

In the course of investigations by the Management Board and Supervisory Board of MIFA, it has been detected that also the previous years’ financial statements contain material misstatements. These misstatements relate to the inventories of raw materials, consumables and supplies as well as finished goods. Recent findings show a cumulative inventory difference in the amount of approximately EUR 19 million, which originate from the financial statement 2012 and previous years.

This is what I wrote 7 weeks ago, just based on public information:

I do not claim to really understand what MIFA was doing and I have no idea if they will survive or not. However, just by looking at their historical material costs and inventory level, it seems unlikely that the newly introduced accounting system could be responsible for a 15 mn loss. For me it is much more likely that the inventory build up at least since mid 2012 lead to overstated results over a longer period of time. The 15 mn loss announced seems to contain a significant write down on inventory as well. I could imagine that they might have to restate older financial statements as well.

Both, stock and bond look like “terminal decline”:

It looks like that the company lost money for a long time and made profits only by faking inventory levels.

I have often said that Grman listed Chinese companies are fraud, but clearly we have a lot of “home grown fraud” here as well. It will be interesting to see if someone is going to jail for this. I guess not

German utilities / decommissioning liabilites

Some months ago, I looked briefly at Eon’s nuclear decommissioning liabilites, which, in my opinion were clearly under reserved as the discount rate of 5% is far above anything being used elsewhere. That’s what I wrote back then:

EON has 16 bn EUR of reserves on its balance sheet for the decommissioning of nuclear power plants. Those 16 bn are clearly already reserved in the balance sheet, but as they will be due in cash rather sooner than later, they should be clearly treated as debt and added to Enterprise value.

However, there is a second issue with them: For some reasons, they are allowed to discount those amounts with 5% p.a. This is around 2% higher than for pension liabilities which in my opinion is already quite “optimistic”. They do not offer any hint about the duration of those liabilities, but if we assume something like 10-15, just adjusting the discount rate to pension levels would increase those reserves by 3-5 bn and reduce book value by the same amount.

I was therefore quite surprised that there seem to be negotiations that the German Government will take over those liabilities. Here is a “Spiegel” article in German which points ut that there seem to be supporters for this on the political side.

The argument made is that if the Government takes over the liabilities, they would not bear the credit risk of the utilities. However that argumentation has some serious flwas:

– the German utilities have indeed made reserves on their liability side, but they are clearly NOT backed by cash on the asset side. In the table I linked to one can clearly see that the liabilites are only partly financed by liquid assets. If we take out working capital requirements, my assumption would be that less than 50% is backed by liquidi assets.

– as I said before, the current liabilites are clearly underreserved. Without knowing anything about the technical aspects, alone the 5% discount rate used indicates 20-40% under reserveing depending on the duration of the liabilites and based on EON’s cost of debt. Clearly if the German Government would take over the liabilities, we would need to discount at German Government rates meaning the fair value or better cost to the taxpayer might be more than 50% more than reserves.

If the utilities would be succesfull with this, both, EON and RWE would be a strong buy and the German taxpayer a strong sell. Maybe I should hedge my position as a German tax payer with a long position in RWE and EON ?

Hess AG (DEDE000A0N3EJ6) busted German IPO stock – Could the fraud have been easily detected ?

Just yesterday, Hess AG, a company which IPOed on the German stock exchange on October 25th 2012, announced that they fired both, their CEO and CFO because of alleged balance sheet manipulations.

The stock price directly crashed some 60% to 6 EUR (IPO price 15,50 EUR):

In some follow up news, the company reported that sales might have been inflated and the financial position might not be as good as stated in the IPO prospectus.

As a value investor, one wouldn’t invest in IPOs anyway.

The Hess AG IPO was priced at levels which one could only assume as “optimistic”, with a trailing P/E ratio of ~50. The price was justified with the supposed “growth” the company was showing in the past and the “story” of the “LED” based business model.

As usual, all parties involved in the IPO (Banks: Landesbank BaWü, Kempen, MM Warburg) will claim that they knew nothing and that you cannot protect against fraudulent management.

The auditors of course will claim the same, in the IPO prospectus they stated explicitly (in German) the follow:

Nicht Gegenstand unseres Auftrags ist die Pr¨ufung der Ausgangszahlen, einschließlich ihrer Anpassung an die Rechnungslegungsgrunds¨atze, Ausweis-,
Bilanzierungs- und Bewertungsmethoden der Gesellschaft sowie der in den Pro-Forma-Erl¨auterungen dargestellten Pro-Forma-Annahmen.

This says they explicitly didn’t check the underlying figures.

The big question of course is: Were there any red flags in the presented numbers ?

How do you “fake” sales anyway ? Well, this is quite simple. You have to organize some kind of “strawman” first, then sell the stuff to him/her and book the proceeds against receivebales. So whenever one sees a large increase in receivables, one should be extremely cautious.

In the case of Hess AG, one does not need to be a Rocket scientist to “smell the rat”. I have extracted the following working capital items from the balance sheet (page 64):

6M 2012 2011 2010 2009
Inventories 17.3 14.8 11.7 9.6
receivables 24.1 22 11.5 8.5
Payables 9.8 4 2.2 1.3
Net Working cap   32.8 21 16.8
“Sales”   68.3 55.7 52.4
Inv/sales   21.7% 21.0% 18.3%
Rec/Sales   32.2% 20.6% 16.2%
Payables/Sales   5.9% 3.9% 2.5%
NetWC/Sales   48.0% 37.7% 32.1%

So it is pretty easy to see, that receivables compared to sales almost doubled over 2 years. The increase in receivables almost exactly mirrors the actual increase in sales. It looks like that almost all the sales increase were actually generated by sales against receivables.

The next item to check is of course the cash flow statement. Here however we see something strange:

6M 2012 2011 2010 2009 Total
Op CF 3.4 -4.6 -1.4 3.6 1.0
inv CF -7.3 -7.9 -1.5 -6.9 -23.6
Fin CF 6.2 14.2 2.3 2.6 25.3

At first it looks that in total, operating CF over the last 3 1/2 years was positive and the company did just invest a lot. But how did they manage the Turnaround ?

In the IPO prospectus they say the following (page 89) about the operating cashflow:

Operativer Cashflow
Vergleich der Halbjahre endend zum 30. Juni 2012 und 2011
Der operative Cashflow erh¨ohte sich von TEUR -3.133 im ersten Halbjahr 2011 um TEUR 6.494 auf TEUR 3.361 im ersten Halbjahr 2012. Wesentliche den operativen Cashflow bestimmende Faktoren waren ein erheblicher Mittelzufluss aus der Position „Veränderungen der Forderungen aus Lieferungen und Leistungen und sonstigen Forderungen und Vermögenswerte’’ in Höhe von TEUR 8.130 gegenüber einem Mittelabfluss im ersten Halbjahr 2011 in Höhe von TEUR 638, der Rückgang des Mittelabflusses aus der Veränderung der Vorräte in Höhe von nur TEUR -652 gegen¨uber TEUR -3.043 im ersten Halbjahr 2011 sowie eine deutliche Erhöhung der Position Abschreibungen in Höhe von TEUR 2.086 gegen¨uber TEUR 1.255 im ersten Halbjahr 2011. Gegenl¨aufig verhielt sich die die Position „Veränderungen der Verbindlichkeiten aus Lieferungen und Leistungen und sonstiger Verbindlichkeiten’’, die zu einem deutlich erh¨ohten Mittelabfluss in Höhe von TEUR -7.976 im ersten Halbjahr 2012 gegen¨uber TEUR -1.719 im ersten Halbjahr 2011 f¨uhrte.

This statement clearly shows that there is something very fishy going on. In the table I extracted above, we can clearly see that there was a NEGATIVE effect from receivables and inventories in the first half year and an unexplained very POSITIVE effect from payable. So why do they state the exact OPPOSITE in their explanation of the cash flow statement ?

Explanation 1: They just mixed up the vocabulary (which would be already a reason to fire the CFO)

Explanation 2: They included other balance sheet item here in order to obscure the fact that they have inflated sales.

Explanation 3: The 6m 2012 cashflow statement is just fabricated and does not fit together with the (fabricated balance sheet)

Just for fun, let’s compare the balance sheet positions with the entries in the operating cashflow statement:

OP CF statement Balance sheet   calculated Op CF Delta stated
  6 M 2012 30.06.2012 31.12.2011    
Change in inventory -0.7 17.3 14.8 -2.5 -1.8
Change in receivables 8.1 24.1 22 -2.1 -10.2
Change in short term payables -8.0 9.8 4 5.8 13.8

We can clearly see that the 6m “flow” numbers have absolutely nothing to do with the delta of the respective balance sheet numbers.

At that point in time one could already stop and conclude that there is either total incompetency or already fraud. Even taking into account all the other short term balance sheet figures, one never gets to the stated cash flow numbers.

In my experience, strongly rising receivables combined with an incomprehensible or even wrong operating cashflow calculation are a very reliable “red flag”.


Although it sounds like “Monday morning quarterbacking”, a relatively superficial analysis of HEss AG’s IPO prospectus would have discovered some serious issues with receivables and operating cash flows. Whe someone starts to doctor around with fake sales, one usually gets negative operating cashflows. If the cashflow statement then looks incomprehensible or wrong, actual fraud is quite likely.

In cases like Hess, “red flags” in that magnitude could even be a very good indicator for an interesting short opportunity. In cases like Reply, where the inconsistencies are on a smaller scale, it is rather a hint to stay away from investing.

Edit: If someone thinks that Hess is now a good investment, because it is so “cheap”, then forget it. Eevn if there is some “sound” business left in the company, first of all there is no proof that they ever earned money and secondly I will assume that there will be quite some legal action on that one.

China Forestry Holding – eine weitere zweifelhafte Agrar Aktie aus China

Vielen Dank erstmal an User Raymond_james für seinen Hinweis auf China Forestry, die Zitat:

trotz branchennähe nicht die geringsten parallelen zu Asian Bamboo aufweist

Kurzes googlen ergibt folgenden Artikel im Wallstreet Journal:

The first thing to note about the company is that it’s a Chinese natural-resources company at a time when natural resources are a hot investment story in China. And surely even the worst-run timber company ought in theory to be positioned to capitalize at least a little bit on China’s construction boom.

One might then notice the matter of land valuation. Skeptics of China Forestry’s IPO have noted its statement that its profits in the three years leading up to its offering arose almost exclusively from the appreciation of its forest-land holdings rather than from operations. That would raise questions for an investor looking to put money in a forestry company. But to others it would represent a useful form of acumen.

Consider China Forestry’s success so far in obtaining land at “favorably low” prices. While the company warned that this might not continue indefinitely—quoth the prospectus, “sellers may become increasingly sophisticated about the valuation and prices of their forests and may demand higher premiums for high quality forests”—that loss of advantage isn’t necessarily inevitable or imminent.

Hmmm….Irgendwie kommt einem das doch bekannt vor ? Interessant ist, dass Top Private Equity Firma Carlyle hier mit einem 11% Anteil dabei war.

Ein Top Investor in der Liste der Anteilseigner ist also auch nicht unbedingt ein Kennzeichen für eine seriöse Chinesische Firma.

Es bleibt spannend.

Short Asian Bamboo – China Background Infos

Fairerweise sollte man im Hinblick auf die hohe Shortposition bei Asian Bamboo in den USA auch auf die aktuellen Entwicklungen verweisen. In USA sind generell viele der dort gelisteten China Firmen in Verdacht geraten.

U.a. prüft die SEC gerade in mehreren Fällen, siehe hier: Bloomberg Artikel

The SEC on Dec. 21 sanctioned a California audit firm for signing off on fraudulent financial statements made by a Chinese energy company. Auditors have come under scrutiny for signing the financial statements of China-based firms accessing U.S. markets through reverse mergers, in which a closely held company acquires a publicly traded company and can then sell shares without an initial public offering.

Bekannt ist for allem “MuddyWaters” durch den Research Bericht zu RINO geworden Sell Rino. Rino hat den Betrug mittlerweile auch zugegeben.

Andere Beispiele findet man z.B. auch im Bronte Blog China Media Express

Wir glauben, dass man auch diese Entwicklung im Auge behalten muss. Sollten sich mehrere dieser Fälle bestätigen, könnte das natürlich Auswirkungen auf alle China Aktien mit Auslandslisting haben.