FTX Is a Signal to Brush Up on Your Red Flags- Here Is How To

Only when the tide goes out do you discover who’s been swimming naked, as Warren Buffett famously said. After more than a decade or near-zero interest rates and the mother of all stock-market parties, the tide of free money is most definitely receding. The bankruptcy of Sam Bankman-Fried’s FTX empire is a foretaste of what may be to come. While the crypto world dances to an arcane beat that may be only tangentially connected to the realm of conventional finance, it’s emblematic of more straitened times that a business valued at $32 billion only a few months ago couldn’t find anyone to put up the extra funds that would enable it to keep going.

If history is a guide, the uptrend in corporate failures to be expected from rising costs of capital is likely to be accompanied by an increasing incidence of fraud. The Enron Corp. and WorldCom Inc. scandals both blew up in the years after the bursting of the dotcom bubble, another period of near-free money, at least for companies that could tinge themselves with a new-economy aura. Bernie Madoff’s investment firm finally collapsed during the nadir of the global financial crisis in 2008, exposing the world’s largest-ever Ponzi scheme. In the UK, Polly Peck International Plc expanded rapidly during the go-go 1980s before foundering in the 1991 recession. Its chief executive officer was later jailed for theft. The 1997-98 Asian crisis uncovered abuses across some of China’s international trust and investment corporations. The list goes on.

“You’re going to get a lot more frauds,” Christopher Leahy, Singapore-based managing director of research and advisory firm Blackpeak Group, told the Asian Corporate Governance Association conference in London. With a recession coming, “we should prepare ourselves,” he said. “Everywhere you look there are potential land mines.”

It may be time for investors to brush up on the forgotten skills of scouring balance sheets, profit-and-loss accounts and cash-flow statements for red flags. It wouldn’t be surprising if these fundamental building blocks of value investing have atrophied in the post-crisis era. The practice of finding and buying companies that are trading for less than their intrinsic worth hasn’t worked out too well for much of the post-crisis era. Little wonder: Who needs the downside protection of conservative finances and margin of safety when companies can shake the magic money tree for whatever they need? Those easy conditions are receding in the rearview mirror, though. Here are some broad principles that may give you a chance of spotting the next listed company fraud scandal before it blows up:

• Read the accounts, duh. More importantly, read from the back. The front is where the pretty pictures, colorful charts and corporate spin go. The notes at the back, usually voluminous pages of densely typed text and figures, are where anything unpleasant gets buried.
• Don’t ignore the obvious. The Madoff fraud was always hiding in plain sight. Former security industry executive Harry Markopolos repeatedly provided the Securities and Exchange Commission with a list of red flags, such as his suspiciously consistent returns. His scheme had swelled to $65 billion before it collapsed. An old investment adage holds: If something is too good to be true, it probably is. All those who invested with Madoff ignored that cautionary wisdom.
• There are no stupid questions. Accounting can be fiendishly complicated. For all that, it’s driven by a basic logic. Balance sheets have to balance. And if the accounts are so convoluted that they can’t be understood even by a numerate reader familiar with financial statements, then perhaps the company doesn’t want you to understand them — raising the question, why?
• Watch for anomalies. Pay particular attention to anything that looks unusual or doesn’t appear to make sense. Leahy told of one Indonesian company that his firm was engaged to scrutinize on behalf of a potential investor, which suspected that something wasn’t right. Eventually, it found a disclosure in the notes of a $60 million cash outflow, with an explanation that conflicted with what the company had said elsewhere. “There’s a reason people do transactions,” he said. “If there’s a transaction that doesn’t make sense, then you have to find out the reason.”
• Listen to whistle-blowers. Most whistle-blowers are insiders who know what is happening inside their company and are unhappy about it, according to Leahy. They played a part in the downfall of Enron and WorldCom. There is a lot of potential downside in being a whistle-blower, and very little upside. That means they deserve to be taken seriously — though by the time a whistle-blower’s report becomes public, you’re probably already too late to avoid a loss.

No country has a monopoly on fraud. Accounting scandals span markets across the world, from Wirecard AG in Germany, to Parmalat SpA in Italy, to Olympus Corp. in Japan. And the variety of potential red flags is too numerous to list: overstating revenue; understating liabilities; excessively high inventories; contradictions between the income and cash-flow statements; unexplained loans; excessive numbers of related-party transactions — to name just a few. Whole books have been written on the subject, notably Howard Schilit’s Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports. It might be time to give that another scan. Happy reading.