Detecting Companies' Malpractices

Excellent article posted on Star Business: How to detect companies' malpractices

• Saturday January 10, 2009
  
  How to detect companies' malpractices
  
  Investors have lost thousands and millions due to companies’ malpractices but there are ways to detect the warning signals
  
  Following the revelation of the shocking Bernard L. Madoff’s US$50bil Ponzi scheme, there has been much uproar over the US regulator’s incompetence in failing to uncover a swindle of such mammoth proportions.
  
  Madoff’s Ponzi scheme is possibly the largest financial fraud in US history. Questions have been raised as to how this could escape the eye of the Securities and Exchange Commission.
  
  Thousands of enraged investors have accused Maddoff of stealing their life savings.
  
  Here in Malaysia, while not of that magnitude or of the same nature, investors have found their investments dwindle due to significant accounting-related mishaps.
  
  Transmile Group Bhd, a once-upon-a-time darling, rattled investors by its accounting fraud. Then, there was optical disc producer Megan Media Holdings Bhd which incurred huge debts and losses over “massive collusive fraud”. When discovered in August 2007, Megan Media was grappling with losses and debts to the tune of over RM1bil.
  
  The dramatic exposure of Transmile came to light in mid-2007, when auditors discovered fake receivables sitting on Transmile’s books. From a market cap of RM3.89bil at its high of RM14.40 on Jan 3, 2007, the company has now been reduced to a dismal market cap of RM155.32mil.
  
  Since then, Transmile shareholders have collectively lost billions. Not surprisingly too, Transmile has been announcing losses in its quarterly earnings since.
  
  There were, however, some shrewd fund managers who managed to escape unscathed from the Transmile episode. Trusting his gut, a fund manager from a local firm sold his Transmile shares at the peak, just before the issue erupted. He tells how he was already feeling uneasy with management’s consistent evasiveness during analyst briefings.
  
  “Management was avoiding some of the questions we asked. They could not give me a straight answers,” says the fund manager.
  
  What are the signs?
  
  Investors who have been victims of fraud are probably angry and want retribution. Before that happens, maybe watching out for red flags would be more helpful.
  
  When choosing to invest in a stock, MIDF Amanah Asset Management Bhd chief executive officer Scott Lim says a key criteria is honesty in management.
  
  He is wary of companies, which during company visits, tell fund managers one thing but announce a different thing altogether. He believes the company should be totally transparent and try their best to explain their actions to all shareholders.
  
  “Whether the fund manager is a majority or small shareholder, they should have total access to information. If the company is beating around the bush, and not being direct in their answers, I think it is time to sell their shares,” he says.
  
  A fund manager who had the bad experience of being deceived by a second board Malaysian-listed company, says investors should be careful when management promises unrealistic returns.
  
  Looking at the character of captain of the company is also important. “If they are the sort who veils everything, very tight lipped, won’t give much information to analysts or shareholders, and are combative in nature, it’s time to be careful,” he says.
  
  He says another red flag is when companies are unable to articulate a clear strategy or are vague on how it gets its returns.
  
  Kumpulan Sentiasa Cemerlang head of stock research and partner, Choong Khuat Hock, admits that it is not easy to spot a fraudulent company, but there are a few signs one can watch out for. “I would still look at the balance sheet. If the company has a very high debt level, or has a business model that relies on a lot of capital expenditure to grow, then I would be wary,” he says.
  
  He adds that companies that are trying to boost their earnings to maintain their past track record, could also fall prey to fraud as there could be attempts to manipulate their books. “This was probably what happened to India’s Satyam group. They needed to increase earnings to meet analyst expectations,” he says.
  
  Recently, Satyam Computer Services Ltd chairman Ramalinga Raju resigned after saying he falsified accounts and assets. Raju unsuccessfully tried to sell two companies to Satyam last month in a final attempt to plug 50.4 billion rupees of “fictitious assets” on the company’s balance sheet.
  
  Choong also advises investors to invest in companies which possess a consistently good corporate governance track record.
  
  “Avoid companies that have dabbled with related party transactions or have been involved in buying over family-related companies. The company may do it again. Sometimes a leopard doesn’t change its spots,” he says.
  
  The local fund manager tells shareholders not to be complacent even when the captain behind the company appears to have a lot of integrity. “You have faith in the person. You see good profits and hence, may abandon common sense. But when the company guarantees a certain level of performance, be suspicious. Be very doubtful if his track record looks too good to be true, because it probably is,” he says.
  
  He adds that if the investment manager’s record seems remarkably steady over a long period of time, it ought to provoke scepticism. After all, markets fluctuate between good and bad times. If returns continue to be good despite market fluctuations, it doesn’t make sense.
  
  Like a Ponzi scheme, a pyramid scheme depends on keeping its volatility low, so that victims don’t start thinking of cashing in en masse. The moment that happens, the game is over, and shareholders get burnt.
  
  Nonetheless, there are many times too that shareholders fall for financial scams simply because of their own gullibility.
  
  This can be explained by the “irrational exuberance factor”. This is the tendency of humans to model their actions, especially when faced with affairs they don’t entirely comprehend, on the behavior of other humans.
  
  So, if a stock is deemed solid and full of potential by most fund managers, then the investment must be good and most people flock to buy the stock. Still, and as many bitter episodes have shown, it is no guarantee of capital preservation.