How to identify (and avoid) the next fad, fraud or failure

While the world is awash with a menagerie of successful companies - those with brilliant management teams, societal shifting products and services, and captivatingly loyal customers - there is still an underbelly of companies benefitting from fads and fraudulent behaviour.

Having recently spilled some ink on the subject, it's become quite clear (to me, at least) that despite historical business busts operating in different industries, there are often similar signals flashing red, warning investors of what's to come. 

They may be in a business's balance sheet, or in a company's reliance on cheap debt. Perhaps it's an absence of bad news, an outward assault of short-sellers, strange acquisitions, or an over-opportunistic chief executive. As one of our readers astutely put it, if it sounds too good to be true, it often is. 

Despite the similarities, it remains a tricky part of the market to navigate. After all, there are countless stories of investors being burned by betting it all on a company masquerading as something it is not. 

Luckily, Totus Capital's Ben McGarry and Perpetual's Anthony Aboud have shared their secrets to identifying the not-so-great companies of the market, which in their case they may short, but in the typical investor's case would be best to steer clear of. 

Plus, they also highlight the types of companies (without naming names; nobody likes a lawsuit) that have caught their attention for all the wrong reasons. 

Let's dive in, shall we? 

Signs to look out for when identifying fads, frauds or failures

All together, McGarry and Aboud point to seven different red flags that they look out for as an indication that there may be troubles ahead for a burgeoning business, listed below: 

1. Questionable or optimistic accounting/cashless profits 
2. Unsustainable business models 
3. Overly promotional management 
4. Insider selling 
5. Sudden departures of key leaders within the business - particularly its CFO 
6. Strange acquisitions 
7. Criticising short-sellers 

By using these red flags, investors can get an idea of the fate that awaits a business, Aboud says. 

"I am of the view that the management team either consciously or subconsciously know the problems before the rest of the market does. Therefore, analysing their behaviour can give you a lead indicator of problems ahead," he says. 

Putting these red flags to work

1. Optimistic accounting

Having previously pointed to Slater & Gordon (still listed) and Babcock & Brown (liquidated in 2009) as historical business busts, Aboud notes that optimistic accounting was evident in both these cases. 

"For Slater & Gordon, recognition of revenue for personal injury is extremely subjective and relies on assumptions around case wins, what the insurer is willing to pay and how aggressive the client will negotiate the fees. In hindsight, they were a little optimistic," he says.

In the case of Babcock & Brown, "more than an extremely large portion of earnings" were being generated by the selling of assets from the parent company to the satellites owned by Babcock & Brown, Aboud says. 

These were heavily geared, he adds. And having overpaid for these very assets to boost the parent company's profit, when the satellites ultimately collapsed, they took Babcock & Brown down with them.

2. Unsustainable business models

While McGarry agrees that the first point of call for investors is to look at a company's financial statements, and match up cash collections to reported profits, the second is to really think about whether the stock's business model is sustainable. 

"Look out for business models that are obviously unsustainable - where somebody is missing out, or getting a really dud deal," he says. 

"It could be the employees of the company, it could be customers of the company, it could be the investors in the funds for a listed investment company. Or it could be the environment or the taxman." 

Eventually, these factors will come back to bite a business, McGarry says. 

"If you're treating your customers badly, they're not going to come back. A business might be very profitable for a period of time, but it's unsustainable," he says. 

"The same goes if you're treating your employees badly. Your profits are probably overstated because eventually, you're going to have to increase their wages to keep them." 

Or perhaps, in the case of a listed investment company, the underlying funds aren't actually making any money, which in turn will be bad for investors over the medium term, McGarry adds. 

"For example, Linc Energy (liquidated in 2016), an underground coal gasification company, was burning coal seams underground in Queensland and causing land subsidence and contamination of the water table and all sorts of things," he explains. 

"Whilst it looked economically sensible on paper, it was clearly unsustainable from an environmental point of view and the government ended up shutting down their test plants." 

For a business to be successful, everybody has to win, McGarry says. If customers and employees win, generally shareholders will win too. 

"But if somebody's missing out big time, the shareholders usually end up wearing that cost," he says. 

3. Overly promotional management

In addition, both McGarry and Aboud argue that overly promotional management should trigger a warning signal for investors.

"The best businesses really get on with running their business. They are not presenting at conferences. They are not all over Twitter. And they are not constantly releasing new products in very public forums," McGarry says. 

"When I see CEOs at every broker event, constantly on the road talking to investors and then constantly raising money, it makes me wonder who's running the underlying business and what is the product? Is the product the shares, or is there a real business here underneath it?"

He points to some of the world's best companies - Berkshire Hathaway, Amazon, Alphabet, as examples of those that get on with business. 

"Buffet and Munger do an AGM once a year and everybody gets their chance to ask them their questions and the rest of the year they're on the tools, trying to make money for their shareholders," McGarry says. 

"Amazon's Jeff Bezos doesn't get on investor calls anymore. We've been shareholders in Alphabet for nine years, the parent company of Google, and have never been able to get a call with investor relations because they don't need to talk to small funds in Australia - the results speak for themselves."

Meantime, while Aboud says he understands that entrepreneurs who have built their businesses from scratch may err on the side of over-promotion, there are two key signals that the astute investor can look out for. 

"The first is the frequency with which a CEO may brief the market, as well as appear in the newspaper," he says. 

"We would rather the CEO be knuckling down and letting the numbers do the talking." 

The other key for investors to look out for is management's inability to disclose bad news, Aboud says. 

"We see this a lot. A company will come out with an ASX announcement for something pretty immaterial but positive for sentiment, but will keep mum about any negative development in their industry," he says. 

Aboud says he is all for the power of "positive thinking", but notes that the implications of this behaviour can be twofold. 

"First of all, we worry that if a CEO is not telling us about some obvious bad news, then there might be other negative issues bubbling under the surface which are a bit less obvious," he says. 

"Secondly, we worry that a company with a culture of brushing aside negative news and just focusing on the positives is not a great culture from a risk management perspective."

4. Insider selling

I have been told several times during my time at Livewire that insider selling is a key red flag to look out for. After all, if the CEO of a business realises their company is trading at lofty valuations and sells to pocket some profits, it's a pretty clear sign that you should too.

"One of the red flags we take a lot of notice of is if we see management teams or founders sell their stock," Aboud says. 

"While this is definitely not fool-proof, in combination with a few other red flags, it can give some signals of problems ahead."

Aboud says typically, the reasons for boards or management teams selling stock would be for tax, divorce, or diversification reasons. While the aforementioned are all understandable, he still prefers CEO's and founders who are "all in". 

"Buying shares in companies where the founders and management is selling doesn’t sit well with me generally," he says. 

"It is for this reason that we are generally pretty cynical of IPOs where there is a significant sell-down from the existing shareholders (especially private equity, who are very good at making the forecast period earnings paint a very rosy picture)." 

5. Sudden departures of key leaders within the business - particularly its CFO

While Aboud notes that there are some instances where investors may rejoice when a CEO announces they are leaving, generally speaking, an abrupt departure of key management is a red flag. 

"There can be some perfectly understandable explanations, but all other things being equal, it gives us reason to stop and pause," he says. 

"What does this member of management know about this company that I don’t which is forcing him or her to bail?" 

However, the biggest red flag for investors should be when a CFO announces their departure, Aboud says. 

"A CFO tends to know any problems in the future earnings well before the CEO knows," he says. 

And now, thanks to LinkedIn, every punter and his neighbour can closely monitor senior management at the companies in which they are invested. 

"If we see a raft of senior management leave in quick succession this may indicate either a cultural or structural issue within the business," Aboud says. 

6. Strange acquisitions

Back to the examples of Babcock & Brown and Slater & Gordon. In both cases, Aboud explains, these were companies that needed to grow aggressively due to their poor operating cash flow. 

"Acquisitions can hide a lot of sins," he says. 

"For Babcock & Brown, the $8 billion acquisition (along with its satellites) of Alinta was the beginning of the end for the company. In the case of Slater & Gordon, the $1.2bn acquisition of Quindell was definitely a strange acquisition and ended up disastrously for shareholders." 

The market cheered on the acquisition due to its massive earnings per share accretion - which is a terrible reason for an acquisition, Aboud adds. However, it ignored the fact that Slater & Gordon were buying a company with similar "work in progress" issues that it had - with "accounts which hadn't been audited for over 15 months". 

"Following the acquisition, Slater & Gordon had a 40% gearing level, which was on the high side for a company with very low tangible assets and poor operating cash flow," he says. 

"It may be an understatement to suggest that the acquisition did not go to plan. But as it unravelled, it showed that some of the previous revenue recognition for Slater & Gordon may have been on the optimistic side."

7. Criticising short-sellers

A common thread among many corporate collapses is that management teams blame short-sellers for all their sins, Aboud adds. 

"Short-sellers are market participants who are taking a view on the direction of the stock," he explains. 

"While the quality of some of the more recent short reports has been quite poor and some have been riddled with mistakes and seem designed to use innuendo to have maximum short term impact on share prices, the same could be said about a lot of long reports." 

Despite that, Aboud maintains that short-sellers cannot be blamed for the unsustainable business models of fallen companies.  

"Short-sellers cannot be blamed for the high levels of leverage, nor can they be blamed for boards and management materially overpaying for acquisitions," he says. 

"However, even in liquidation, there are countless examples of non-executive board members using short sellers as a reason for companies failing

The sources of future fads, frauds and failures

Both McGarry and Aboud have identified several business busts within the Aussie market (although we will not be naming them here). However, the sources of future company collapses are arguably fair game. 

"While there have been some large accounting shenanigans overseas (like Wirecard), we are not seeing as many here in Australia," Aboud says. 

"I believe it is because, thanks to Amazon’s enormous success, investors by and large don’t care as much about accounting profits any more. Therefore, there is less incentive for companies to artificially inflate their profit." 

Instead, the market is currently focused on narratives such as the size of a company's "total addressable market" or TAM, he says. Equally, they may choose to weigh revenue growth over actual profit.

Although this could change over time, Aboud believes that future collapses will likely come from three sources: 

1. Old school businesses with new disruptive companies taking market share or facing other structural headwinds. If combined with a stubborn board and an overgeared balance sheet, then danger lies ahead.

2. Companies in hot sectors which underestimate the competitive response from existing or new market participants. We are starting to see signs of companies investing significant amounts of money in marketing and CAPEX with the sole purpose of generating revenue growth given that is how these companies are getting valued. There does not seem to be any focus on sustainable cashflow or profits. If the market environment were to change (either through increased competition or change in consumer preferences) this could end badly for more than a few of these profitless companies.

 3. Companies reliant on cheap funding for their entire business model and will struggle when interest rates inevitably normalise. 

Meantime, McGarry notes that since the lows of the COVID-19 crisis and the subsequent share market boom, "there are a lot of companies with quite high valuations that are having to dress up their accounts to flatter profits". 

He points to trends such as the "capitalisation of costs".

"In recent years, some companies have expensed things like research and development, others capitalise that cost on the balance sheet and their profit looks a bit higher," McGarry says. 

"I think there's been a trend towards slightly more aggressive accounting of late, which means there's a selection of companies that we think are probably pedalling quite fast to maintain their valuation. There's a selection out there, but nothing that we would want to have a pitched battle with management on at the moment in the Australian market." 

However, McGarry agrees with Aboud that ultra-low interest rates have allowed unviable businesses to "fund themselves almost indefinitely and kick problems down the road".

"As we are witnessing in the Chinese property sector this week, eventually these problems do come home to roost. But getting the timing right on when it is going to happen is extremely difficult," he says. 

If rates do indeed start to rise, or if investors start to demand an economic return on their capital, there are several sectors that could be in trouble, McGarry says. 

"Leading brands might survive, but it’s hard to see much of a moat in 3^rd and 4^th tier Buy-Now-Pay-Later operators, for example, as the market gets increasingly competitive, marketing spend is rockets and losses balloon," he says. 

Capital moves in cycles, McGarry adds. 

"There is an old saying that the best cure for high prices is high prices," he says. 

"Be careful of hot sectors where there is a lot of capital being invested into new capacity as this can lead to oversupply and busts. As we have just seen in iron ore, things can turn quickly."

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