Like many deep value investors, I have benefited tremendously from Nate Tobik's writings at OddballStocks. His recent post on 'Portfolio strategies: The definitive guide to net-nets' caught my attention, as he summarized his thoughts on net-net investing in a single article, covering a diverse range of topics such as risks, fraud, profitability, asset composition, quality, portfolio construction, financials and sell discipline.
I have written about the issues of value traps, asset valuation and fraud with respect to net-nets here at GuruFocus previously. Today, I will like to expand on the topic of fraud risk, more specifically involving net-nets.
I agree with Nate's view on the fraud risk of net-nets.
Firstly, he mentioned that net-nets are no more susceptible to fraud than other stocks, if you rule out Chinese companies.
My view is that since net-nets tend to be trading at these depressed levels because of mediocre or disappointing financial results, they are less likely to have manipulated their earnings, compared to let say, high flying growth stocks and market darlings. Instead, any fraud risk with net-nets tends to reside within the balance sheet: fraudulent cash & bank balances, over-stated inventories & accounts receivables; suspicious-looking, bloated other receivables & other current assets.
In particular, look out for a mismatch between earnings and book value growth. For example, if earnings are growing at 2-3% a year (or loss-making for that matter), but asset values are expanding at the rate of 10% or more.
Also, although I invest in Hong Kong-listed stocks, I tend to prefer companies operated and founded by non-Chinese management (management who are Hong Kong and Taiwan residents/citizens). In my opinion, this has less to do with Chinese companies per se, but the fact that any company listed offshore on another country's exchange warrants greater scrutiny. In the event that a fraud unravels, the management of a foreign company listed on a local stock exchange is less likely to be 'punished' for his or her actions, be it actual prosecution or damage to one's reputation.
Secondly, Nate added that there is a need to investigate further if things look too good to be true and finally move on, if you are not satisfied with the risk-reward proposition following your investigation.
I share my three-step research process to minimize fraud risk here.
Step 1
I eliminate stocks which fail the Beneish M-score test (scoring greater than -2.22). Without going into too much details, the M-score helps to detect risk of earnings manipulation using indicators such as receivable days, accruals and asset quality (proportion of non-PPE long-term assets) etc.
Step 2
I avoid companies which err on the wrong side of corporate governance or simply had a tainted history. Some time ago, I was running through the balance sheet of a Hong Kong-listed net-net investment and found a 'pleasure boat' recorded on its books. I didn't buy the stock.
More recently, I gave up the opportunity to invest in two profitable dividend-paying net-nets. One of them had the history of a proposed privatisation offer at 4 times P/E which was blocked by an activist investor; while another one had a CFO who formerly worked at another suspended-for-trading company suspected of financial irregularities (it is telling that the company chose to employ such a person).
Step 3
I keep a list of stocks which have been targeted by well-known short-selling investment research firms like Muddy Waters, Citron Research and Anonymous Analytics.
It is better to be safe than sorry. On its website, Muddy Waters Research mentioned that its nine “Strong Sell” reports have led to four de-listings, four resignations of auditor / CFO / board members, and six or more formal investigations by regulators into covered companies. In May 2014, Citron Research reported that it has gained on 12 out of 15 of its short positions since 2013.
Closing thoughts
If you take care of the downside, the upside will take care of itself. Investors typically suffer permanent loss of capital, if the company is either fraudulent or bankrupt. Of course, there will be some 'false positives.' But I will rather forgo the opportunity for a few multi-baggers, in exchange for stocks with minimal fraud risk.
