How to avoid investing in a fraudulent company

Founder and director of investment website JustOneLap.com, Simon Brown. (Photo: Finweek)
Founder and director of investment website JustOneLap.com, Simon Brown. (Photo: Finweek)

Holding shares in a company that is accused of fraud is one of the worst feelings in the world. 

You’ve done the work, decided this is an attractive investment and you like the valuation. You buy into the company; all is going well and you’re now actively looking for the next potential investment. Sure, you’re keeping an eye on results and other announcements, maybe monitoring the sector they operate in as well as peers in the sector. All seems great. Then, bang, a Sens announcement or news article comes out, alleging fraud. 

Your first response is likely disbelief. Surely you couldn’t have been wrong? Denial is probably your next reaction, as you refuse to believe it as you watch the share price collapse.  

Sometimes we do get it wrong. In fact, getting it wrong occasionally comes with the territory for investors.  

The issue is that spotting fraud is incredibly hard to do, because at the heart of any fraudulent activity is the art of concealment, which is usually only committed by a few people in the company who do everything to hoodwink everybody. 

But there are some tools we can use that could at the very least raise some red flags. 

I have written before about going back a couple of years and reading the chairperson’s annual statement and what they have to say about the future prospects for the company. Are they seemingly always getting it wrong? Maybe they’re lying to shareholders, or maybe they are just not very good at their job. 

Another red flag is hype or buzz words that sound great and hit all the right notes but actually reveal very little about the business and how it plans to make real profits. Coupled with this is complexity – when it’s hard to fathom how a company really makes money or what they do. Sure, complexity can be profitable, but it also offers plenty of space to distort the true picture. 

A tool that I first came across about five years ago is Benford’s Law. Benford’s Law states that in any dataset the frequency of the first digit of every number is not random. There will be more numbers starting with 1 and a lot less starting with a 9. The law states that 30% of all numbers should start with 1, while almost 20% should start with 2; 12% with 3; and under 10% start with 4. The least frequent starting numbers are 7, 8 and 9, and one of these three numbers should only occur as the starting number about 5% of the time. Even for a company with large numbers, this law will still apply and can help us spot potential fraud. 

As investors, we need to be looking for red flags as much as we’re looking for good reasons to invest. The hard part is that when we see these flags, we need to respond accordingly.

Many fraudulent companies that have now been busted saw their share prices run up for years before the reveal and ultimate collapse. Heck, many are probably never caught. But to reduce our odds of ever holding a fraudulent share, we need to take heed and rather skip an investment that worries us with its red flags. This way we’ll miss out on the sickening feeling in our stomach when the fraud is revealed.

This article was written exclusively or finweek's 26 June newsletter. You can subscribe here.

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