One of the biggest fears for investors is to bet their money in fraudulent companies. High profile cases like Enron, Worldcom and Noble Group to name a few. Once the company you have invested in have been caught in the limelight or under suspicion for fraudulent activities, you will inevitably see their share prices plummeting the next day. Cutting the loss would then be extremely painful.
However, one of the biggest issue for investors is not about how the authorities are not doing enough to prevent them. Because realistically they are doing everything they could. Instead, the issue is that it is not easy to detect them. Even trained accountants and regulators have failed to spot the damage until it is too late.
However, it is not impossible to continue investing profitably with the potential of putting your money in fraudulent companies.
Here are 4 ways that you can use to protect yourself against fraudulent companies:
1. Understand the Situation
To be realistic with you, unless you are a highly trained forensic accountant, there is literally no way for you to pin point a fraudulent company before the scandal is discovered. Every company you invest in has a potential to be fraudulent. Our best bet is to minimize our chances and build protection if such cases do occur.
It’s roughly similar with the way you might live your own life. You want to avoid getting sick or acquiring serious diseases. So, what do you do? You exercise regularly while eating healthy and keeping a balanced diet.
But even by doing all those, you could not eliminate the risks completely. That is why you should buy insurance. This is the exact approach we will take when investing in the stock market with potential landmines.
2. Learn Accounting
Accounting is the language of business. If you want to significantly reduce your chances of being a shareholder of a fraudulent company, then inevitably, you need to learn accounting. But you do not need to pursue or invest a significant amount of money to get an ACCA, ICEAW or even CFA qualification (although it can be rather helpful). You only need one basic accounting knowledge, which would be enough to help you assess whether a business is doing well.
In fact, there are plenty of free resources online. Simply search for them on Google or Youtube. Without these knowledges, you are basically investing in the dark and would have no idea what is normal or abnormal in the financial reports. The best part is that these skills you picked up will feed you and minimize your risks of investing in fraudulent companies for a lifetime.
3. Invest Only in Great Companies
There are many indicators to tell whether a company is deploying suspicious accounting practices. You can learn about them but there’s a high chance that you would likely be unable to. Or find them too troublesome/tedious to apply. Again, this is because as a retail investor, we are not trained to be forensic accountants. So how do we reduce the risks then?
Invest only in companies with strong track record of wonderful performance.
You see, for a management team to commit these crimes, there needs to be a motive. If the company is doing very well over many years, consistently paying out good dividends, and shareholders applauding and thanking them every year for their efforts, who in their right mind would consider cooking the books? It is totally illogical for them to do so.
Management teams who consider practising fraudulent activities most of the time have incentives to do so. Either their performance is tied to the company’s profits, but they are unable to maintain profitability, or they expect their share price to go up but are unable to set up the foundation and fundamentals to increase the company’s value over time. Only then would they resort to these fraudulent activities. But like most crimes, it wouldn’t last very long. Criminal activities will always leave clues behind and there is no way for the management to completely cover their act.
If you have explored one of the biggest fraudulent cases of all time; Enron. For a company that generates $40 billion in revenues in 1999, it raises eyebrows when they’re able to generate $100 billion in revenues in 2000 which is more than a 100% growth. It is abnormal for a company of such size to grow so rapidly in just 1 year alone. Despite the rapid growth in revenues, net profit only grew by 10% which is a ridiculous difference.
See the clues of dishonesty?
Such clues later led to investigations and they were discovered after only a few years of dishonest accounting practises. However companies such as Disney, Facebook and Nestle lasted for many years without facing such issues.
4. Build a Portfolio
Our philosophy is to always invest in a way that allows you to make mistakes because eventually mistakes is bound to happen. Having a portfolio allows you to spread your risks across a variety of stocks instead of having them all in one basket.
Imagine if you have $100,000 to invest and you put them all into a single stock. If that stock turned out to be fraudulent, then you would have definitely lost all of that $100,000 immediately. But if you invested only 10% or $10,000 into a stock that turned out to be fraudulent, you would only lose a maximum of $10,000. But what about the returns of your other positions? It will be unlimited.
Limited losses unlimited returns. Sounds like a good deal.
As the legendary investor Warren Buffett once said, “we do not have to do too many things right as long as we do not do too many things wrong”.
In summary, you need to be practical when it comes to dealing with the risks of potentially investing in fraudulent companies. The key is not to spend too much time determining if the companies are fraudulent but to focus on keeping the risks low so that we can generate profit safely from the stock market. By applying the 4 steps above, the risk of investing in fraudulent companies can definitely be lowered.
Disclaimer: All facts and opinions presented are for educational purposes only. This is not a recommendation to buy or to sell. The author involved in the writing of this message has no vested interest in the companies. Please consult a professional for expert financial or other assistance or legal advice.
This article was written by Team VIC
Team VIC is formed by experienced and well-trained individuals from Value Investing College (VIC). The team has been consistently studying the latest stocks market trend in order to focus on educating the layman on investment principles and techniques.