The Worst-Kept Secret on Wall Street

The worst-kept secret on Wall Street... How to spot 'financial red flags'... The key to finding fraud doesn't start with the numbers... Uncovering deception before everything unraveled... Policing the 'Wild West' of the stock market...

Editor's note: Last September, we introduced Digest readers to Professor Joel Litman...

Several years ago, Joel developed an innovative way to figure out the true earnings and profitability of some of the best- and least-known stocks in America. And last year, he brought this approach to everyday investors through our corporate affiliate Altimetry.

Now, Joel and his team of analysts are tackling a new endeavor... what he calls the "Wild West" of the stock market.

So today, we're taking a break from our usual Digest fare and turning things over to Joel. In today's essay, he discusses his team's work to uncover fraud in the stock market. As you'll see, you shouldn't always begin by focusing on the numbers...

In late 2010, one of our largest clients called us in a panic...

One of its biggest holdings, coffee maker Green Mountain Coffee, had just received a data request from the U.S. Securities and Exchange Commission ("SEC") stating it was launching a formal investigation into the company's accounting.

Our client needed to know what to do... immediately. If the company was fraudulent, the stock could drop to zero – potentially wiping the fund out alongside other shareholders. But if Green Mountain's accounting was clean, the stock could experience a massive rally.

So my team and I (Joel Litman) went to work.

It's a poorly kept secret that most people on Wall Street have no idea how to analyze financial statements...

Most of the high-powered hedge-fund portfolio managers, analysts, or private-equity managing directors don't come from an accounting background.

They generally have experience in investment banking or consulting. Their job is to know the companies, the people, the players, and the industry inside and out.

Others are quantitative analysts – math pros who can bend numbers to yield the insights they're looking for. But these folks don't know the difference between earnings before interest, taxes, depreciation, and amortization ("EBITDA")... net working capital... or deferred revenue. It isn't what they're paid to do.

When accounting questions come up, the reaction is, "It's all Greek to me." That's why nine of the top 10 biggest money managers on the planet call up my team and me to help.

Back when I was an accountant, I was fortunate enough to study under two mentors who were literally the auditors to the auditors. They both were the authors of the GAAP Guide – what many consider the "bible of accounting."

They helped teach me how to analyze the financial statements... but most important, how to analyze the people behind the financial statements.

Altimetry Director of Research Rob Spivey grew up around accounting, too. He worked in corporate accounting roles in two Fortune 500 companies before he crossed over to the world of finance. He learned firsthand all the tricks of the trade for corporations about legally managing their books. He learned how to put himself in the shoes of those preparing the annual and quarterly reports.

On top of that, when we built our team of analysts in Manila, Philippines, we went out of our way to fill our staff with accountants – CPAs, or folks on track to become CPAs – who would understand not just what the financials were saying, but the background of the financials.

As such, our team has built a core competency on understanding and identifying when management may be playing games with the accounting – or "financial red flags," as we call them.

And just as important, we're able to determine when management is being falsely accused of playing games with the accounting.

While we have a strong accounting background, it's not our team's understanding of the numbers that helps us identify questionable activity from management.

The truth is...

Finding management who plays games with the numbers doesn't often start or end with the accounting...

If you want to find companies that might have red flags, don't start by analyzing the numbers... start by analyzing the people.

That means looking at who the auditors are, management's background and history, how management is compensated, and analyzing management's communication.

In the case of Green Mountain, the SEC was concerned that the company artificially inflated revenue by having a distributor take on inventory and then recognizing it as revenue when it wasn't really sold yet. So we started by first analyzing Green Mountain's partners...

The SEC worried that Green Mountain had built significant accounts receivable with a brand-new partner, M. Block & Sons. The distributor went from nothing to 51% of Green Mountain's receivables... That type of explosive growth in non-cash revenue is a meaningful signal that management might be artificially boosting revenue.

We immediately researched M. Block and found it was an independent distribution business that various coffee and other vendors across the globe had used for years. M. Block had no reason to help Green Mountain artificially boost its earnings.

We also analyzed Green Mountain management's earnings calls and identified that executives weren't showing any signs of deception when talking about the distribution growth with M. Block, related to the growth of coffee system Keurig.

Before even looking at the accounting, we already knew fraud was unlikely – we knew to audit the people behind the accounting, and everything came up clean.

Asking the right questions helped us come to the conclusion that Green Mountain was in the clear. We relayed the information, and our client stayed in the stock. The client made a massive profit as the stock bounced back... and as Green Mountain's stock rose higher when Keurig took off.

On the other hand, our analysis has turned up some of the biggest red flags you could imagine...

In early 2011, snack maker Diamond Foods announced that it planned to acquire Pringles from Procter & Gamble (PG) for $1.5 billion in stock. At the time, one of our clients who considered building a position in the stock approached us for help.

Our client was concerned with rumors about Diamond's accounting for its payments to walnut growers. Additionally, the cost savings that the company was telling Wall Street it could generate from a merger with Pringles looked suspiciously low... like Diamond was artificially understating how much savings it thought it could generate.

Our team got to work and analyzed the people and actions behind Diamond's payments to the walnut growers.

Diamond had significant leverage on the books from its prior acquisition spree, when it had bought Kettle Foods, Pop Secret, and products from Harmony Foods over the previous five years. Key covenants in Diamond's debt required it to keep earnings high, so as to not get on the wrong side of debtors.

On top of that, the company targeted an all-stock acquisition of Pringles. To convince Procter & Gamble that giving its investors Diamond stock was a good idea, the company needed to show strong and growing net income.

Those facts helped explain why management might have had the intent to manipulate Diamond's accounting. As we said, to identify fraud, you need to find a management team who has reason to play games.

This information made us question whether management may have been manipulating earnings.

Then, we found the most damning piece of evidence...

When we analyzed management's calls about the Pringles merger, whenever management talked about those pesky synergies, they generated signals in our "Earnings Call Forensics" process that suggested they were hiding something.

Remember, Diamond Foods was rumored to be "sandbagging" its potential savings from the Pringles acquisition – understating expectations so it could post better-than-expected results. And on the earnings call, management's comments appeared to confirm exactly that.

It's far too easy for a motivated management team to commit fraud and hide it from less-aggressive auditors. It can go on for some time... Fraud often only becomes apparent when companies want to bring the financial statements back to reality.

Management tries to start reporting what the company is really doing. This sets off a big swing in the numbers that triggers warning bells for investors, auditors, and anyone else paying even a little attention.

Diamond management wanted to wrap up the games it was playing with the accounting. Management's solution for hiding that it was cleaning up how it reported its walnut growers' payments started and ended with Pringles. The company would offset its higher real costs on its legacy business with more savings from the Pringles acquisition than management was telling investors to expect.

The company would use the Pringles acquisition to cover up its previous shady accounting.

Fortunately, we told our client to stay away from the investment. Diamond couldn't keep up the façade... Eventually, other people caught on to the same issue that we had identified months earlier. Making matters worse, the walnut growers started getting more vocal about being underpaid.

And then, everything unraveled...

Diamond had to delay the closing of its Pringles acquisition. Procter & Gamble got cold feet and pulled out of the deal.

The SEC started to investigate the payments and identified that management played games with the timing and size of its payments to the walnut growers.

Concerns about Diamond's credit position and accounting led to the stock's collapse. It fell from more than $79 per share in September 2011 to less than $14 per share by late 2012. More than $56 million in earnings came out of the company's financials... and Diamond Foods had to pay $5 million in fines to the SEC. Tragically, the story ended with one of the directors taking his own life when he realized the repercussions of what the company had done.

We saw it all before the company's stock completely collapsed because we weren't just paying attention to the accounting... We were focusing on all the people and factors that lead to the accounting. We were looking at fundamental forensics.

Today, we're using this analysis in a part of the market where it's most needed...

It's an under-the-radar space that our big institutional clients have never been willing to pay attention to.

For every big-cap Green Mountain Coffee or Diamond Foods that may (or may not) be engaging in questionable activities, dozens of these firms exist in the tiniest stocks in the market – microcaps.

Institutional investors, journalists, and the SEC all police the biggest companies in the stock market. These companies can rarely do something questionable because so many eyes are on them.

But in the microcap world, the same level of supervision doesn't exist. It's the Wild West. Because of that, many investors are afraid of these stocks.

That's why we've decided to launch a brand-new product to put those concerns to rest. In Microcap Confidential, we analyze the tiny companies that no one else is monitoring.

First, we identify the businesses that are set up like Diamond Foods – companies where management teams are out for themselves and not looking out for shareholders... and where we see other red flags that suggest the stocks could go to zero.

If we can do that successfully, then we can identify the businesses that aren't playing games – the tiny companies that have massive, 1,000% upside.

Many of these companies have huge tailwinds at their backs. And since microcaps start so small, they don't need to do a lot for their stocks to rocket higher.

You'll rest easy by owning these tiny, unfollowed names – while knowing we've done the same investigatory work we did for Green Mountain, Diamond Foods, and others. We're doing our due diligence to find the safest stocks with the biggest upside.

To learn more about Microcap Confidential – and how to gain access to the seven microcaps primed for big gains ahead – click here.

New 52-week highs (as of 7/15/20): ProShares Ultra Nasdaq Biotechnology Fund (BIB), Cameco (CCJ), Sprott Physical Gold and Silver Trust (CEF), Emergent BioSolutions (EBS), Fortuna Silver Mines (FSM), Fidelity Select Medical Technology and Devices Portfolio (FSMEX), SPDR Gold Shares (GLD), Home Depot (HD), Hecla Mining (HL), KraneShares MSCI All China Health Care Index Fund (KURE), Lonza (LZAGY), MAG Silver (MAG), Pan American Silver (PAAS), ResMed (RMD), Rollins (ROL), Global X Silver Miners Fund (SIL), Silvercorp Metals (SVM), TFI International (TFII), and Wheaton Precious Metals (WPM).

In today's mailbag, feedback on yesterday's Digest that touched on e-waste and the value of garbage. What's on your mind? Tell us at feedback@stansberryresearch.com.

"'Only' 1/35th ounce of gold in a cell phone? And not very easy to extract... By my math, that converts to 0.88 grams/phone.

"On Seabridge Gold website, Hole 72 at the KSM site is highlighted, having 0.86 g/T over 800+ metres etc, – and think about all the processing needed to extract THAT gold, hidden in a tonne of rock. Kinda interesting I think." – Paid-up subscriber Mark E.

"While I agree that the trash business is 'sticky' in the sense that people always need their trash removed, recession or not, it doesn't seem like a very capital efficient business to me. What am I missing?

"The simplistic way I see it, there is limited ability to add new customers to an existing route (i.e., existing employees and existing truck) before you hit capacity and need to add a new truck and new employees. Where am I wrong?" – Paid-up subscriber Michael V.

Corey McLaughlin comment: We're not just thinking about individual garbage routes and trucks. The entire waste-disposal network also includes assets like landfills. If owned and operated the right way, they can be extremely valuable.

As we mentioned yesterday, editors Dan Ferris and Mike Barrett described the trash business in detail in their June issue of Extreme Value. If you're not already a subscriber, we encourage you to give their newsletter a try, risk-free today.

Regards,

Joel Litman
Boston, Massachusetts
July 16, 2020