How to Invest and Not Get Killed

A company’s financial statements can be an investor’s best friend, or biggest foe.

If read carefully, an investor can gain valuable insights into the company – like finding durable sustainable moats a la Buffett.

However if these statements are read without care, and one acts upon his hunch, thinking – “Let me buy the stock since it’s rising! I’ll read the annual report later.” – he or she can lose his/her entire investment.

Like it happened in the case of Deccan Chronicle recently, or for that matter, Suzlon. Of course there are hundreds of other companies that come to mind, but then that’s not the point here.

The point is that some financial statements shout out to be read – and carefully – by investors who are buying into these stocks without looking into the deep mess the balance sheet and cash flows are hinting at.

If you have been a buyer of such messy businesses in the past, and have now vowed to find out the red flags that lie within a company’s financial statements, there is one book you must read right away.

The amazing book I’m talking about is “Financial Shenanigans” written by Dr. Howard Schilit.

I have not found a better book than this to jump start an investor’s detective accounting work. It is highly descriptive, practical and applicable if you have the intention of using the simple tricks suggested in this book in real life.

“Shenanigans” are basically actions or omissions designed to hide or distort the real financial performance or financial condition of a company.

The reason these exists in so many financial statements are manifold, like…

• These omissions can have huge paybacks (higher profits, performance linked bonuses etc.)
• These may help company obtain financing at undeserved terms
• Companies omit things to prevent negative outcomes
• Omissions are made to dispel negative market perceptions (especially during bull markets)
• These are easy to do
• It’s unlikely you will get caught

Anyways, since you are already interested to know more what these shenanigans are, here is a post that a tribesman Anil Kumar Tulsiram recently submitted on the Safal Niveshak Forum.

I found the post compelling enough to be read by a much wider audience, and thus I’m sharing what Anil wrote in his review of “Financial Shenanigans”, including some of his (and mine) personal examples from the Indian market (marked in italics).

Over to you, Anil.

Review of Financial Shenanigans
I have made note of some key points from the above book. I thought it can act both as a review of the book and also help readers to take the discussion on fraud forward.

Highlighted in italics are the instances, where I could co-relate the points mentioned in the book with some of the Indian companies.

Why you must read: I think this book is a must read for any investor as:

1. It shows the various ways fraud has happened in the past in the developed world,
2. It suggests additional analysis which can be performed to detect fraud early, and
3. It shows why you must not rely on cash flows blindly, as even cash can be manipulated.

Though other than Satyam, this book does not contain any examples from Indian companies, even then I believe that it will be helpful for Indian investors.

Key points highlighted in the book
Companies with structural weaknesses or inadequate oversight provide a fertile breeding ground for shenanigans.

Investors should probe a company’s governance and oversight by asking these basic questions:

• Do appropriate checks and balances exist among senior executives to snuff out corporate misdeeds?
• Do outside members of the board play a meaningful role in protecting investors from greedy, misguided, or incompetent management? (To my knowledge majority of the companies in India fall under this category) (Vishal: Heard a senior corporate governance expert reveal that independent directors open their mouth just once in a board meeting – to pop in cashew nuts!)
• Do the auditors possess the independence, knowledge, and determination to protect investors when management acts inappropriately? (Always be wary of companies that have not changed their auditors for years) (Vishal: Singhi and Co. has been auditing the accounts of Hindalco Industries for the past 50 years…like Chaturvedi and Shah, Deloitte Haskins and Sells and Rajendra and Co. are doing for Reliance Industries for at least 35 years. How can auditors be independent after so many years of continuous relationship? But who’s asking these questions?)
• Has the company improperly taken circuitous steps to avoid regulatory scrutiny? (I do not have an Indian example but I remember a Hong Kong based company China Grand Foresty where the company got listed by way of reverse merger with a listed company, allegedly to avoid scrutiny and disclosure required for a new listing. After experiencing a dream run on HK exchange, ultimately it was discovered that company was a total fraud. Read the full story here.)
• Boards lacking competence or independence (Appointment of film actor Shah Rukh Khan and Yash Raj Chopra to board of directors of Jet Airways. Regarding explanation on expertise in relevant field, this is what the company said in the resolution – “Mr. Shah Rukh Khan is a well-known Actor from the Indian Film Industry. He is the recipient of Thirteen Filmfare Awards, three National Honours including Best Indian Citizen Award in 1997, Rajiv Gandhi Award for Excellence in 2002. In 2005, Mr. Khan was conferred the Padma Shri, one of the prestigious civilian honours conferred annually by the Government of India. He is also recognized as a cultural ambassador of India to the rest of the world.” I fail to understand in what way Mr. Khan’s expertise would have been useful to the company)
• Failure to challenge management on inappropriate compensation plans (There is no dearth of examples for this in Indian scenario. For instance, Naveen Jindal of Jindal Steel and Power pays himself Rs 73 crore annual salary!)
• Failure to challenge management on related party transactions (On 16th Dec. 2008, Satyam passed a resolution to acquire Maytas which was into an unrelated field, and got its board of directors to approve the transaction. Shareholders still had 15 days before the share price collapsed completely).
• Be wary of companies where a single person dominates the management and board? (Vishal: Think L&T and Mr. AM Naik)
• Be skeptical of boastful or promotional management. Investors should be particularly careful when a management publicly boasts about its long consecutive streak of meeting or exceeding the markets’ expectations? (Vishal: Suzlon, Kingfisher)
• Astronomical fees lead to conflicted independent auditors.

Red flags
Here are some red flags that you can find in a company’s financial statements:

• Sharp jump in receivables, especially long term and unbilled.
• Cash flow from operations materially lags behind net income.
• Be wary of companies using percentage of completion method (especially engineering and construction companies), as there are more chances of using aggressive assumptions.
• Watch out if non-recurring expenses/extra-ordinary expenses have been recurring.
• Do not get excited by the results of a company for few quarters after it has written off certain assets, as it is possible that it is the result of writing down good inventory or assets.
• Watch out for companies which try to include non-core income to boost operating margins in times of stress or economic slowdown.
• Increase in capex, without corresponding increase in sales indicates that the company might be capitalizing normal operating expenses.
• Rapidly growing fixed asset accounts or “soft” asset accounts (e.g., “other assets”) may be a sign of aggressive capitalization. Create a quarterly common-size Balance Sheet (i.e., calculate all assets and liabilities as a percentage of total assets) to quickly identify assets that are growing faster than the rest of the Balance Sheet.
• Inflating revenue right after closing on an acquisition is a pretty simple trick – Once the merger is announced, instructs the target company to hold back revenue until after the merger closes. As a result, the revenue reported by the newly merged company improperly includes revenue that was earned by the target before the merger.
• Look out in the notes to account for disclosure regarding securitization or factoring of receivables. It is possible that a company facing stress in collection of receivables will simply sell its receivables on recourse basis (meaning – even if debtors fail to repay, the company still needs to pay to the bank) and record it under operating cash flow. (Example: As per Sanghvi Movers’ FY12 annual report, bills receivable which were discounted with bankers was Rs 28 crore (previous year Rs 5.7 crore). This is the highest amount of discounting by the company in the last five years which never exceeded Rs 10 crore even during the 2008-09 crisis. Now there is no information whether sale of receivables is on recourse or without recourse basis. This become even more scary when we consider that they derive almost 30% of their sales from Suzlon, which is struggling with huge amount of debt.)
• Be wary of serial acquirers, as its difficult to understand operating cash flow. (Example: When the acquired company collects receivables or liquidate inventory, it is recorded under operating cash flows, while the company had made purchase of inventory or sales prior to acquisition and so these transactions were never recorded as operating cash flow.)
• Boosting operating cash flows by making slower payments to vendors. Watch out for increase in payables.
• Watch out if the company stops disclosing any key metric and argues that it does not indicate the company’s performance accurately.
• Auditors rarely disagree with management, so if they do disagree with management on transaction of significant magnitude, in all possibility it gives indication of some wrong doing.

About the Author: Anil Kumar Tulsiram (Anil) has over 10 years of post-qualification experience. Since Mar. 2012, he is into full-time independent investment in the Indian stock market using value investing principles and currently investing his own money. He is a Chartered Accountant and a Chartered Financial Analyst (USA). He is greatly influenced by investing philosophy of Tweedy, Browne partnership firm, Martin Whitman of Third Avenue Fund and Prof. Sanjay Bakshi. Connect with Anil.

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Lessons for you
Thank you Anil for this nice review!

For you, dear investor, shenanigans of all sorts are found in companies of all sizes and across all industries. So a big size, which commands some respectability, is no guarantee against financial frauds.

That said, if you are investor in small companies, which lack solid internal controls, professional internal and external auditors and a competent and fully engaged board, you must be on high alert.

Especially watch out for these very common shenanigans that many companies use:

• Inflating revenue by recognizing it too soon (sharp rise in receivables will tell you that)
• Recording bogus revenue (like recording refunds from suppliers as revenue)
• Boosting profits through large one-time and unsustainable incomes (like profit on sales of assets and investments etc.)
• Shifting current expenses to later period (improperly capitalizing costs, depreciating or amortizing costs too slowly, or failing to write off worthless assets)

These are in fact among the most harmful for investors since these help companies hide serious deterioration in their businesses.

These are also indicative of dishonest managements.

Anyways, on being asked in an interview his advice to investors when it comes to reading financial statements, Dr. Schilit said…

Very simply – investors should read any “commentary” by management or sell-side analysts at the very end of the process. Start with reading the actual financial statements (Balance Sheet, Statement of Income and Cash Flows) and accompanying footnotes for at least two periods and look for changes – in account titles, accounting principles, estimates. After you have concluded your analysis and evaluation, then read the commentaries found in the Management Discussion & Analysis, Letter from the President, other subjective reports by “friendly” sell-side analysts. Also, interview management when you have read all these documents and be alert when management is giving evasive or untruthful answers.

Finally, to repeat Charlie Munger’s quote – “All I want to know is where I’m going to die so I’ll never go there.”

The companies silently committing financial shenanigan are going to kill you, if you invest in them!