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Rupert Hargreaves
Rupert Hargreaves
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How to Identify Frauds: A Framework

Some thoughts from the CIO at Gladstone Capital Management

June 17, 2019 | About:

One of the most prominent problems investors have is trying to identify frauds or corrupt companies. More often than not, these frauds are not discovered until it's too late, and investors end up suffering.

This isn't just related to fraud. According to some estimates, around 10% of businesses fail every year, and avoiding these collapses is not always possible.

Martin Stapleton, chief investment officer at Gladstone Capital Management, has done a tremendous amount of work over the past few years on identifying the hallmarks of a failing company. He's completed more than 240 case studies on failing companies and used this information to build a failed company framework.

A framework for fraud

Speaking at a discussion organized by UC Berkeley in San Francisco of the critical issues, technologies and policies that drive financial fraud around the world, Stapleton described his fraud detection framework, which is based on years of research.

The investment manager has identified what he calls a fracture and pressure framework for identifying inevitable failures. This framework is based on the conclusion drawn from case studies that, in most cases, companies display several so-called fractures in their business models before entering distress.

These fractures include items such as increased inventories, a change of auditor, management replacements and poorly thought-out acquisitions. According to Stapleton's research, however, companies displaying these fractures can persevere for years without collapsing. These problems start to become terminal when pressure is added to the mix.

In his discussion, Stapleton highlighted South African retailer Steinhoff International as an example of what happens to fractured companies when pressure is applied. Before the group blew up towards the end of 2018, it displayed several red flags, including, but not limited to significant non-core acquisitions, a high level of borrowing, many related party transactions, management changes and an entrenched management team.

The company managed to muddle through with these issues until pressure was applied to the business. In this case, the consumer environment in Steinhoff's core markets -- South Africa, Europe and the U.K. -- started to weaken, which put pressure on management, sales and cash flow. As the pressure started to build, it wasn't long before the fractures turned into full-blow cracks and the business collapsed.

The markers to look for

In total, there are 36 markers in the framework. If the majority of these red flags are present, and pressure is applied, the business is likely to fail.

Stapleton did not detail all of the issues he looks for, but he did say that he's looking for qualitative as well as quantitative factors, such as accruals, a change of auditor, revenue growth compared to employee numbers and CEO tenure. His research shows that companies with CEOs who have served for 14 years or more have a higher chance of failing or being outright frauds.

Not easy to find

One of the primary takeaways from Stapleton's research is that frauds and corporate failures are not easy to identify at first. Indeed, of the more than 240 failures he's considered, only 25 were frauds; the rest were just corporate failures where management couldn't cope and made a series of mistakes.

To put it another way, many businesses fail by accident. That's why these failures are so hard to identify before they happen.

The fractures and pressure framework does go some way to alert investors to the red flags that link many failures, but Stapleton was careful to warn that the framework provides only an indication. The higher the company scores, the more likely it is to encounter trouble. But as is the case with most things in business, failure is never guaranteed.

Disclosure: The author owns no share mentioned.

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About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

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