You Can't Fake Cash... or Can You?

You can't fake cash – or can you?... Enron, Parmalat – and now, Wirecard... A task so basic that an intern does it... How to protect yourself from the next company cooking the books... The problem with 'modernity'...

Editor's note: U.S. markets and Stansberry Research will be closed tomorrow in observance of Independence Day. Stay tuned for valuable market wisdom from our colleague Dr. David "Doc" Eifrig in this weekend's Masters Series. And then, we'll return to our normal publishing schedule on Monday evening. We hope you enjoy the holiday.

You can't fake cash...

Investors and Wall Street analysts have sworn by this rule of thumb for decades.

Most of the time, it's true... Cash either arrives in a company's bank account or it doesn't. There's no in-between. That's why this rule can help investors avoid big losses...

This rule of thumb is important because excess cash flow is the source of every business's "intrinsic value" (although we could debate all day in what form or on what schedule the cash may arrive). It's the measure of what the asset – or company – is worth.

Simply put, a business isn't worth much to an investor if it doesn't make more money than it needs to maintain and grow its business. A business that keeps consuming cash instead of generating excess cash is in grave danger of becoming a zero.

Enron is a famous example...

During the late 1990s, the Houston-based energy firm's cash flow statements showed that the business was consuming cash, not generating it. Yet the company reported positive net cash generation in 2000 by counting its proceeds from selling energy assets as cash flows generated by normal business operations.

Due to the quirks of accounting, Enron produced negative cash flows even when the company's income statement showed its earnings were rising.

As it turns out, investors who looked away from the company's fabricated earnings and focused more on cash flows had a much better chance of avoiding big losses in the stock... We now know that Enron's shares went to zero after the company became embroiled in perhaps the most famous accounting scandal in history and ultimately declared bankruptcy.

One of the best things about cash is...

If you're generating plenty of it, it piles up in your bank account.

But what if you're faking your bank account?! No rule of thumb is true 100% of the time... and unfortunately, "You can't fake cash," is no different.

Case in point: Italian dairy company Parmalat...

In December 2002, Parmalat's auditors sent a routine letter to Bank of America to verify a balance of $4.8 billion in an account of one of the company's subsidiaries. The auditor received a letter in return a few months later, verifying the balance.

It was subsequently discovered that the letter to Bank of America had been intercepted by a Parmalat employee... who then forged the favorable reply.

In other words, Parmalat did what's perceived as impossible... It faked its cash.

The past several weeks have provided yet another example of faking cash...

German financial-services company Wirecard appears to have faked a cash balance of as much as €1.9 billion. (That's roughly $2.1 billion in U.S. dollars.)

The Financial Times has been all over the Wirecard story. A telling paragraph from a recent update suggests the fault lies with Wirecard's auditor, accounting mega-firm Ernst & Young ("EY")...

The Financial Times revealed last week that Wirecard's auditors in EY's German office failed for at least three years to request crucial account information from a Singapore bank where Wirecard claimed it had up to [€1 billion] in cash, a routine audit procedure that could have uncovered the fraud.

The Parmalat incident was a sinister plot to forge a letter confirming nonexistent cash, making the auditor as much a victim as the investor (at least in that respect). The Wirecard fakery didn't involve forgery (at least that we know of right now). It does appear, however, to have been exacerbated by the auditor's incompetence...

Fraud and incompetence are bad outcomes for investors. I almost hate to report to you that they can happen even with something as basic as how much cash is in the bank.

Yesterday, I (Dan Ferris) spoke with my colleague and Stansberry Venture Value editor Bryan Beach...

Before joining Stansberry Research, Bryan worked as an audit team leader for a major accounting firm. So he's extremely knowledgeable when it comes to these incidents.

Bryan explained that requesting cash-balance information is the easiest auditing task in the business. In fact, auditing teams typically give this job to interns and first-year accountants.

The novice employees send a confirmation letter to the bank, which is usually a large institution with a whole department dedicated to checking balances and returning letters. Then, after the balance confirmation comes back and the interns have done their job, three levels of management recheck and sign off on their work.

In other words, if EY really failed to confirm Wirecard's account balances for three years, its team must be the worst auditors on the planet. As Bryan said, it's the hardest thing to screw up in the auditing business. And EY supposedly did it for three straight years...

As the Financial Times also reported, "that €1.9 [billion] of cash probably never existed."

Of course, EY claims it's the victim of fraud as well...

The company provided its partners with talking points "to assist with client discussions." When legal hassles arise, you must know exactly what words will most likely keep you out of trouble.

Perhaps one day, the truth about Wirecard and EY will come out...

When the truth about Enron came out, it led to the shuttering of Arthur Andersen's auditing business. The company's rapid fall from grace took less than nine months to play out.

The bottom line is... if you really want to fake your cash balance for the purpose of defrauding investors, you can do it. Because of that, investors can't afford to be lazy.

Sure, we can count on most companies to not engage in fraud...

But as we've seen so far in 2020, unlikely things happen every day in this world... and all you need is one blow-up to erase a meaningful chunk of your hard-earned net worth.

Perhaps by now, you're thinking, "OK, Dan, I get it. Fraud happens and even cash can be faked. But why are you telling me all of this? How do I make money from this situation?"

You make money by learning all about what can go wrong that could cause you to lose it all...

Remember, I'm the "via negativa" guy. I'm the one who spends more time showing as many folks as I can what to avoid in investing and life... rather than what to do.

Regular Digest readers know I've been focused on risk for years...

My bookshelves are filled with titles about risk, crises, losses, failure, and fraud.

A few years ago, I even bought a 416-page, spiral-bound technical guide called Lost Person Behavior. Search-and-rescue workers use it to learn how to find people who get lost while traveling on land, air, and sea (which happens a lot here in the Great Northwest). It's loaded with practical insights, like the fact that most folks who get lost in caves...

... tend to be male, marginally equipped, have no formal training, and continue to move until the light source fails. They are often agitated by fear and anxiety.

Sounds like a lot of day traders.

I focus on risk because it's the way real finance experts grow and preserve investor capital...

But I also do it because so few people in the financial-research business want to. I try to stand out from the crowd by plucking the low-hanging, high-value fruit of risk avoidance.

In financial circles, everybody and his brother is trying to sell you something... They're trying to get you to buy this or that security or investment. And yes, ultimately, if you don't put at least some of your capital at risk, you won't grow it over time.

But what makes us different around here – not just me, but also all of my colleagues at Stansberry Research – is that we're at least equally focused on what you must avoid.

By the time any Stansberry editor has recommended a particular stock, bond, exchange-traded fund, or any other investment... he has probably looked at dozens of alternatives that didn't pass muster. He has exercised his risk-avoidance muscle a lot more than any other.

Every Stansberry editor uses some type of risk control – through deep analysis and/or trailing stops – to help our subscribers avoid losses. It's simply the best way for most individual investors to increase overall returns... By taking your emotions out of the game, you'll be a better investor.

Paul Portesi, a wise fellow who I follow on Twitter, likes to talk about the problems with 'modernity'...

By that, I mean modern ways of thinking that get you into trouble.

One of the problems of modernity, the gist of which I gleaned from a recent tweet of Paul's, is that modernity provides you with the benefit... It never tells you the risk or harm.

I try to focus much more on stories about what can go wrong for investors rather than what can go right. I don't think investors spend enough time thinking about that.

I'm here to pick up the mantle and tell you about the risk and the harm... whenever and wherever I find it.

My head analyst Mike Barrett and I provide actionable "buy" advice to Extreme Value subscribers whenever we find a really good business trading at a truly attractive price. (By the way... we've found another stock this month that rhymes with my two recent "No. 1" recommendations. We'll tell Extreme Value subscribers all about it next Friday, July 10.)

But we also see a fair amount of risk and uncertainty in the air these days...

That's why, besides finding some great businesses trading at big discounts to intrinsic value, Mike and I have also added safer bets over the past several months. We've added recommendations in short-term government bonds and some of the best stores of value you'll find... like cash, precious metals, and even bitcoin. (I should also note that portfolio manager Austin Root has added some of these to his Stansberry Portfolio Solutions products, too.)

Anybody who reads my Digest essays knows I like to sing the same song often and loudly...

While preserving wealth falls into the "avoid risk/harm" bucket... in the cases of precious metals and bitcoin, it also comes with enormous upside potential.

Just look at recent history...

Gold is up roughly 570% since the dawn of this century (January 1, 2001). Meanwhile, the benchmark S&P 500 Index is only up around 135% during the same period...

I expect that outperformance to keep up for another five or 10 years.

Meanwhile, bitcoin has outperformed everything since its inception in 2009... and it may well do so for several more years as well.

A single bitcoin exchanged hands for about $0.50 in 2010. It's worth about $9,000 today – a mindboggling gain of nearly 1,800,000% in the past decade.

Much more upside potential remains, too, which I believe will be realized as governments around the world resort to the only real lever they have to stimulate economic growth...

Printing money and issuing debt.

Here's what I wrote about bitcoin in the February 2020 issue of Extreme Value...

[Legendary value investor Murray] Stahl says that, due to Gresham's Law, the total market value of bitcoin will tend to move toward the value of the global M2 money supply (a standard measure of global currency in circulation) – around $80 trillion as of a year ago.

Right now, bitcoin's total value is roughly $188 billion, with about 87% of the total potential supply of bitcoin outstanding. To match the $80 trillion in global currency (or any fraction of it), bitcoin will have to rise dramatically in price without increasing supply by more than the 13% that has yet to be created.

That would turn a $2,000 stake into an $850,000 home run. Bitcoin would be a 425-bagger.

Sure, that kind of return is highly unlikely. (About as unlikely as the Internet or e-mail would have looked in the 1960s... And remember, technologies today tend to be adopted at a much faster rate than back then.)

But we don't need to see anywhere near those gains to succeed. If bitcoin replaced 10% of global currency supply, it would be a 42.5-bagger – turning $2,000 into $85,000. I'd say it's worth risking $2,000 to make $85,000.

It's counterintuitive and exciting to me as an investor to learn that stores of value like gold and bitcoin hold so much upside potential... while also helping me build a truly diversified portfolio. And I believe that's more important today than it has been in more than a decade.

I'll always be an equity investor, but...

When I learn the details about frauds like Enron, Parmalat, and Wirecard, it makes me very happy to be holding part of my wealth in some (unfaked) cash, bitcoin, and precious metals.

Value stocks, cash, gold, silver, bitcoin... That's my portfolio right now. It's what my wife and I own, and it's what I recommend my subscribers own. I believe it's an ideal portfolio for the next several years.

Finally this week...

I hear some poor, sad fools want to cancel traditional American holidays – like the upcoming Fourth of July.

I understand being angry because George Floyd died while being restrained by a policeman at the same moment when the federal government is stupidly waging a war on making a living...

But I believe it's a massive mistake to want to cancel a holiday that celebrates perhaps one of the very few revolutions in history where the new regime was better than the old one.

Even so, since all manners of idiots get their way politically in this fading republic, you'd better enjoy Independence Day while it lasts. I know I will!

New 52-week highs (as of 7/1/20): Alamos Gold (AGI), Amazon (AMZN), BlackLine (BL), Crispr Therapeutics (CRSP), DocuSign (DOCU), Electronic Arts (EA), Equinox Gold (EQX), KraneShares Bosera MSCI China A Fund (KBA), Lonza (LZAGY), MAG Silver (MAG), Microsoft (MSFT), Sea Limited (SE), The Trade Desk (TTD), and Victoria Gold (VITFF).

In today's mailbag, feedback on Dr. Steve Sjuggerud's new real estate research... and thoughts on an options strategy that Retirement Trader analyst Jeff Havenstein shared back in May in the Digest.

"Thank you for your recent real estate offer. Most of my money is in real estate, which makes me very interested in [your] recent push in that direction. I'm currently in the beginning stages of developing that real estate and am wondering how I might use your resources to help my efforts. At this point it's a game of wait and see.

"In the meantime, I will follow your efforts with interest." – Stansberry Alliance member O. Donn G.

"I just wanted to give a shout out to all of the Stansberry team to thank you for one of my favorite option strategies (selling puts on recommended stocks I want to buy).

"I love picking up a few extra hundred bucks here and there while I'm waiting for some of your recommendations to fall back a bit after short-term rallies.

"My wife loves to hear about each successful trade... I'm one very satisfied customer for almost 10 years." – Paid-up subscriber Jim T.

Good investing,

Dan Ferris
Vancouver, Washington
July 2, 2020