History is ripe with hucksters. Investors were reminded of this again this month when stock market darling Gowex declared bankruptcy. It turns out the Spanish Wi-Fi provider’s fast growth and profitability were not only unbelievable, they were likely nonexistent. Mere days after the U.S. based Gotham City Research LLC released a scathing report on the company, Gowex’s CEO admitted to having fabricated financials for at least four years.1 By chance, our team witnessed this fall from grace up close as we had looked into the company only months before. This gave us a unique opportunity to learn from the disaster without partaking in it.
Our experience with Gowex came out of a simple exercise. The company appeared on our radar because of its attractive margins, high returns on capital and stunning growth—revenues had leaped over 500% in five years. So we decided to call Gowex management even though we thought valuation was most certainly going to be a deal breaker—the company was trading at a price-to-earnings multiple above 45 at the time. Nevertheless, it was a business model that we wanted to understand.
The call was fascinating. While a typical management interview generally consists of many types of questions, our hour long call with Gowex was spent exclusively on how the company made its money. Even then, the company’s long term value proposition was unclear to us and we questioned whether the company would continue to be profitable in the future. At that point, we dropped our research—when a business is outside our team’s circle of competence, we move on.
On July 1st, Gotham City Research issued its damning report on Gowex.
The following Friday, the CEO, Janero Garcia, allegedly denied any wrongdoing, going so far as to gather his employees to passionately proclaim his innocence and galvanize support against the accusations. He even donned 24 metal pins to symbolize both his resilience and the 24 broken bones he once suffered in an accident.1
The next day, he admitted to the board that the numbers had been rigged for years. By Monday, Gowex had filed for bankruptcy.2
In the investment world, there is no way to avoid the occasional fraud. It is simply a numbers game. The more companies you evaluate, the more likely you are to encounter one. Moreover, it is usually difficult to detect which companies are fraudulent, as companies can have duplicitous management teams and aggressive financials without necessarily breaking the law. We never knew definitively that Gowex was a fraud, even though we saw plenty of red flags and our instincts told us something was off.
So what can investors do to reduce the risk of investing in frauds? We have found that checklists can be helpful. Our team has created a list of specific questions that can help identify red flags—the more red flags, the greater the risk that something suspect is going on.
The Anti-Fraudster Checklist
1. Does the company’s level of profitability make sense compared to its peers or its industry?
One of my colleagues, Peter, once spoke with China High Precision Automation, a company which made various products for industrial automation. Although the company’s financials were extremely profitable and the stock seemed inexpensive, Peter was very skeptical as he believed the company had few competitive advantages and the industry had limited barriers to entry. He noted in our team’s shared company log that the “the qualitative and quantitative pieces do not add up.” This was in July of 2011. On October 27 of that year, KPMG issued a qualified opinion and, by November 29, they resigned as auditors. The company stopped trading December 1.3 Similarly, Gowex’s level of profitability was confusingly high. As Gotham’s report highlighted, Gowex’s revenue per employee was above that of Google’s. Yet the company’s publicly-traded peers – Boingo, iPass and Towerstream – were all losing money and “all prior for-profit attempts to provide free-Wi-Fi on mass market [had] failed.”4
2. Has management chosen to list the company on an exchange with low or high standards? Do they list in multiple geographies for no discernable reason?
Clearly, fraudulent activity can happen in any geography and on any exchange. However, where there are less restrictive regulations, there is a higher probability of duplicity. Exchanges like the Mercado Alternativo Bursatil (MAB) are known for their freer requirements. Likewise, how a company chooses to list matters. In Canada, private companies can use reverse takeovers (RTO) to turn from private to publicly-traded companies, simultaneously avoiding certain costs and a full securities commission review. The alleged fraud, Sino-Forest, is an example of a company that used this technique.5
3. Do all of the assets actually exist? Do all of the operations actually exist?
In any investment, it is never sufficient to take management at their word: some ground research is always warranted. When we originally invested in Retail Food Group, for example, I flew to Australia to have a look at their operations and to test their food franchises. Although I came back a solid 5 lbs heavier, the weight I gained from eating excess meat pies and donuts was worth the additional insight we gained from my review of the operations. Investors who take the time to do scuttlebutt – talking with employees, customers, suppliers and competitors – may avoid some of the more obvious frauds.
For example, when Gotham Research counted the Gowex hotspots on a map, they could only count 5,000 – not even close to the 35,000 to 100,000 believed in the market.
4. Is the company’s disclosure weak? Do they fail to disclose basic operational metrics? Have they changed what was previously disclosed?
Investors must question when management refuses to provide basic operational metrics or changes its disclosure policy. Often, a CEO might refuse to provide a metric due to “competitive reasons.” Sometimes this is the case, but often it is a cop-out. Operational numbers such as store count or distribution centers can be integral to an investor’s bottom up understanding of a company, allowing them to understand the economic nature of customer relationships, conduct scenario analysis and value the stock. When management refuses to provide a key metric, it is suspect.
For example, Gowex refused to provide its hotspot count4 even though it was a wireless hotspot provider. This is akin to a food retailer like Retail Food Group not disclosing its number of restaurants.
5. Is there any evidence of management making false claims?
Leaders with something to hide are often caught making false claims. Yet catching management on false claims can be tricky. One way to evaluate management’s honesty is to look for consistency. Management may tell different stories to different investors, weave different narratives to bond or equity holders, ‘mistakenly’ get the numbers wrong in conversation, or present different information across different languages.
Gowex’s disclosure was different in English and Spanish.4
6. Does the company pay out a dividend?
Companies in a poor cash position are typically reticent to pay out much cash to shareholders.
7. Does the audit relationship seem credible?
Auditors are meant to provide a stamp of approval on the finances of a company, therefore, the audit relationship is a good place to start when searching for suspicious activity. When a firm uses an unknown auditor instead of an established one, it is usually a red flag – although Arthur Anderson’s involvement with Enron clearly demonstrates that even well-established accounting firms can become embroiled in these activities. Qualified opinions or auditor changes can also be potential warning signs, as either one can signal that the auditor disagrees with management’s version of reality.
Investors may also examine the absolute dollar figure of the audit fee and compare it to the company’s revenues and its peers. Gowex paid only €50,000 for its audit, an amount that was 1/10th of what its peers paid and very low given the company’s revenue claims.4
8. Are the customer relationships credible?
Some due diligence questions are required to ascertain whether a company’s customer relationships are credible:
Does management list who the customers are?
Is there evidence that the stated customers have genuine business operations?
Are any of the customers also suppliers, and are there any other strange linkages that may obscure the relationship?
If you call a customer, do they corroborate the same story that management tells you?
For example, this line of questioning led to the discovery that not only were Gowex’s customers also suppliers, many of them did not even have functional websites.
9. Are the supplier relationships credible?
Like customers, the credibility of supplier relationships should be examined. Some suppliers may have familial or other suspicious links to the company. Moreover, suppliers may provide clues as to the accuracy of what management reports. For example, Gowex claimed it earned €100 million in revenue through roaming and offloading, while Towerstream, the supplier that provided half of its network, only generated $1 million.4
10. Is there any evidence of financial shenanigans?
One of the most critical parts of the due diligence process is a forensic accounting review. Using many of the ideas that Howard Shilit discusses in Financial Shenanigans, investors can go through a company’s financial statements to assess the probable extent of financial manipulation. These reviews consider a number of items, such as whether revenues and assets could be overstated, or whether costs and liabilities could be understated. For example, an investor should be skeptical if receivables are growing faster than sales, as this could indicate a more aggressive revenue recognition policy.
On our team, a 54-point forensic accounting exercise is done in tandem with a full review of the company’s historical financials. Although this seems extensive for the small instances of frauds that occur, we find it to be a valuable process as it almost always surfaces some other important information on the company. In our experience, this review provides a deeper understanding of the earnings quality of a business.
Recommended further reading:
1. Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports. Howard Schilit.
2. The Checklist Manifesto: How to Get Things Right. Atul Gawande.
3. Gotham City Research’s report on Gowex
1 As reported by the Wall Street Journal in Gowex’s Lost Magic Quiets Cheers for CEO http://online.wsj.com/articles/the-magic-fades-for-gowexs-jenaro-garcia-1404843472
2 The board filed a voluntary insolvency. Refer to Gowex’s Lost Magic Quiets Cheers for CEO http://online.wsj.com/articles/the-magic-fades-for-gowexs-jenaro-garcia-1404843472
3 In this case, it appears that KPMG resigned because the company would not hand over important documents, citing “state secrets.” As the Wall Street Journal reports, the company was making “continuous effort in cooperating with KPMG” to provide information, but was legally advised not to, as this would potentially violate the “Law of the People’s Republic of China on the Guarding State Secrets.” KPMG alleged there were accounting inconsistencies. To date, no fraud appears to be proven.
5 Sino-Forest was accused of fraud by the Ontario Securities Commission in 2012, one year after the short seller Muddy Waters LLC made similar accusations. The case has not yet been closed, with settlement proposals with the CFO and a shareholder class action lawsuit still in development.
This blog and its contents are for informational purposes only. Information relating to investment approaches or individual investments should not be construed as advice or endorsement. Any views expressed in this blog were prepared based upon the information available at the time and are subject to change. All information is subject to possible correction. In no event shall Mawer Investment Management Ltd. be liable for any damages arising out of, or in any way connected with, the use or inability to use this blog appropriately.