It’s an investor’s worst nightmare. One of the stocks you’ve bought and held turns out to be dramatically overvalued, due to either fraud, a fundamentally unsustainable business, or some other combination of deception and half-truths.
While the vast majority of publicly traded companies are legitimate and honest in their disclosures, reporting, and description of their business, bad apples are by no means unprecedented.
[Read: The 10 Most Anticipated IPOs of 2017.]
From electronics retailer Crazy Eddie’s accounting fraud in the 1980s to Enron and WorldCom in the early 2000s and Bernie Madoff’s Ponzi scheme in 2008, history provides us ample examples of seemingly legitimate investments that were built on a house of cards.
No one wants to build a portfolio with a stock or fund like this in it. So without further ado, here are seven warning signs to look out for that may indicate one of your holdings is pulling the wool over your eyes:
Black boxes. Whenever a company says their revenue or profits are generated in a so-called “black box,” or in a mysterious way that cannot be revealed or fully disclosed to investors, you should immediately become suspicious.
In the months and years before Enron famously fell, there were publicly voiced concerns by Wall Street analysts and financial journalists about Enron’s profits, which were characterized as being generated in a black box, hidden from outside inspection. Enron, in turn, claimed the way it earned so much money was proprietary, and revealing its methods would damage its business.
In the end, Enron’s black box was more like a Pandora’s box, and when investors opened it they discovered revelation after revelation of underreported debts and overreported profits.
Accounting irregularities. While many frauds have irregular accounting practices, not all of them can be easily detected. Sometimes though, the naked eye is enough.
Bob Johnson, president and CEO of the American College of Financial Services in Bryn Mawr, Pennsylvania, notes that something called “common size analysis” — of both the income statement and balance sheet — would have shown something fishy going on at WorldCom before it imploded in scandal in 2002.
“A common size analysis of WorldCom’s income statement over time shows that line costs as a percentage of revenue was steadily and dramatically declining over time and at the same time, property, plant and equipment as a percentage of assets was rapidly rising over that same period,” he says.
Johnson likens the scheme to “renting an apartment but booking the rent payments as equity in the apartment,” and says that the fact WorldCom’s competitors weren’t reporting these strange trends should’ve been a red flag.
[See: 7 ETFs for a Solid Portfolio Defense.]
Behavioral indicators. K C Ma, professor of finance at Stetson University, says there’s a laundry list of behaviors that investors should consider extremely suspicious. Among them:
— Companies start missing scheduled filing dates of financial statements.
— Companies restate their financial statements.
— There’s a change of auditors.
— The CFO or chief auditor resigns.
— Company insiders sell after bad financial reports are released.
— The SEC or IRS seeks documentation.
Suddenly changing accounting practices can also be a tipoff, as can extremely large differences between GAAP earnings and non-GAAP earnings, especially if discrepancies are routine and if non-GAAP numbers are consistently required to show profits.
Poor business models. Poor business models can also be a sign one of your stocks is doomed to failure or is ultimately unsustainable. Doomed business models aren’t actually legitimate business models at all, since they can’t be sustained forever. Examples of these models are Ponzi schemes and pyramid schemes, which ultimately rely on a continuous and ever-larger influxes of new capital to pay off previous participants.
Global nutrition company Herbalife (ticker: HLF) has long been accused of being a pyramid scheme by Bill Ackman and his hedge fund Pershing Square Capital Management, although to date those allegations have not been proven; Herbalife has rebuffed Ackman’s charges for years and its shares currently trade publicly on the New York Stock Exchange.
If something’s too good to be true. An old rule of thumb is written on the SEC website: “Any investment that sounds too good to be true probably is.” For example, the SEC cites “the promise of ‘guaranteed’ returns with little or no risk” as a definite red flag.
This is where Bernie Madoff’s scam was most apparent to the naked eye, even before his fraud unraveled. His “returns” were simply too consistent — and consistently above average — for too long. Some Madoff investors were guaranteed annual returns ranging from 10 to 20 percent, regardless of the performance of the larger market. Madoff’s incredible track record showed routine double-digit returns and an uncanny ability to avoid down years.
Even the best investor of all time, Warren Buffett, has had 10 down years in his 52 years at the helm of Berkshire Hathaway ( BRK.A, BRK.B). The Standard & Poor’s 500 index had 11 annual declines over the same period.
Anything else that stands out from the ordinary. When asked to name indicators he thought investors should watch for to make sure they don’t buy into a lemon, Andrew Left, the famed short seller and founder of Citron Research, has a simple answer: “Anything that stands out from the normal.”
The strange trends in WorldCom’s financials, mentioned earlier, that its competitors weren’t reporting, could be viewed through this lens, for example. Other factors like bizarre answers or outright non sequiturs when management fields analyst questions during quarterly earnings calls could also mean something fishy is going on.
Citron Research is most well-known in recent years for bringing to light the legitimate channel-stuffing claims that brought Valeant Pharmaceuticals ( VRX) crashing down from $257 per share to lows of $8.31 per share, all in less than two years.
Allegations from short sellers. Yet another sign something may be awry with one of the stocks you own is a pretty simple indicator: warnings from short sellers.
While investors should always remember that short sellers have a financial incentive to spread fear and doubt, their warnings can sometimes catalyze a sea of legitimate scrutiny and investigations that reveals their concerns are ultimately valid.
There have been countless times that shorts have pointed out devastating flaws in company accounting or business practices, or even revealed outright fraud, that ultimately leads to catastrophic and justified declines in a certain stock’s price.
[See: 7 of the Best Stocks to Buy for 2017.]
Be aware of hit pieces, research reports and other presentations from prominent short sellers like Citron Research and Jim Chanos, as well as respected hedge funds leveling allegations. While the charges aren’t valid 100 percent of the time, it’s better to be aware of potential issues than remain in the dark.
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