If there is anything to learn from last week's HP-Autonomy saga, it is that, regardless whether it is a microcap or a large-cap, anyone investing doesn't do his own due diligence is a fool. (In case you missed the story, here is the abridged version: HP now thinks it was conned in its US$11B acquisition of Autonomy and has written this investment down by a whoppy $8.8B.)
John Hempton, the hedge fund manager based in Sydney who is short HP, shows how you can spot Autonomy's fraudulent accounts in 5 minutes. As a hedge fund manager, Hempton mainly goes long. He says shorting frauds is only his sideline. But throughout the years, he has dissected many frauds on his blog. If Buffett makes value investing look easy, Hempton makes uncovering frauds look like a child's play. But make no mistake. The look is deceiving. As with any intelligent approaches in investing, "it is simple, but not easy". Behind the scene, a lot of brain power and fact finding are involved. If it were that easy, John Paulson who made his name in betting against subprime mortgages wouldn't have been deceived in the Sino Forest fraud.
Every business is unique. Every fraud situation is also unique in its own way. If you look at how Hempton skillfully deconstructs the meaning of low capex here or high receivables there, you see that almost any single number worth scrutinising. There are infinite variations. So, I don't think it's useful to have just a catalog of fraud detection techniques. Instead, it's more important to internalise the underlying principles, the first principles.
Here are principles I distilled from Hempton's blog:
- Visualise how the business operates from the numbers - Don't fall into the trap treating the numbers as abstracts. When seeing the gross margins going up every year, it's far too easy to tick the "this business has pricing power" box on your checklist and then move on. What is more important is to visualise how the physical goods flow from here to there and how the money flows in the opposite direction. The more vivid it is, the more powerful it is.
- Cast a skeptical eye on any outliner - Continue from the previous point, always ask the question: "what does that very favourable metric mean in the context of the company's competitors and its industry? Is that economically or physical possible?"
- The personalities behind a business are as important as the numbers, if not more important - If you catch 100 burglars in a year, how many of them have only done this once? None? Then, track down the histories of the CEOs, the bankers, the lawyers and the accountants!
- Data point, data point and more data point - Ben Graham says "you are right only if your facts and reasoning are correct". Without the facts, you only have a hypothesis. Look at what Hempton did. He paid "spies" to visit local factories. He took note how often a founder-CEO flew 12 hours to see his mistress living on a different continent.
- It's all about Bayesian reasoning - How to put the collected anecdotal evidence together? You have the evidence (E). You have the competing hypotheses (H), "this business is a fraud" vs "this business is brilliant". You apply Bayesian reasoning, reasoning things in Occam's Razor style, to find the hypothesis (or the theory) that fits the evidence the best, going from Pr(E|H) to Pr(H|E).
I'm writing this post not because I'm an expert in fraud detection or in shorting. Exactly the opposite. I'm a novice. I'm writing this as a reminder to myself.