Beware of short-sellers' targets

The script is almost identical every time: A breed of traders known as short-sellers build up a big "short" position in a company, borrowing shares they do not own to sell in the hope of buying them back at a lower price later on.

They then send out a report, usually over the Internet, accusing the company of dodgy accounting practices or, worse, fraud.

Unless the company in question can mount a successful counter-offensive, it will find the very life drained out of its share price, as investors flee in panic, not bothering to find out whether the accusations are credible or not.

Why should this be the case? Some companies which have come under attack by short-sellers are not exactly fly-by-night operations.

They have included Olam International and Noble Group which have huge business operations generating billions of dollars in revenue, and whose performances are closely tracked by highly paid research analysts.

It, therefore, seems strange that sober-minded investors should choose to believe in the accusations hurled by short-sellers - some of whom do not even bother to disclose their identities - instead of mainstream analysts.

Yet, you can't blame investors for adopting a "be safe than be sorry" attitude, given the uncertain business climate, with even well-known companies such as US giant retailer Walmart posting profit warnings on their results.

Even so, there may be valid reasons for the jitters displayed by investors, despite the indignant rebuttals by company management when confronted with accusations from short-sellers.

One problem, according to Mr Andrew Fastow, the former finance chief of failed energy giant Enron who was jailed for six years for his role in one of history's biggest corporate frauds, is that only 10 per cent of accounting is clear-cut.

The remaining 90 per cent involves a lot of human judgment and this gives companies a lot more latitude and flexibility to interpret the accounting rules.

To give a simple example: Say you sell a batch of goods. Some are faulty and may be returned, hurting your profit. But you don't know what proportion will be returned or when. If you are under pressure to produce a good profit because your bonus depends on it, you would be likely to make an optimistic estimate of the percentage which would be returned.

Mr Fastow, who was in Singapore recently to speak at the Asia-Pacific Fraud Conference, sounded provocative warnings about today's corporate practices and the role he played in Enron's collapse. But the pointers raised by him offer useful insights on identifying the targets on short-sellers' radar.

He noted that there are thousands of assumptions which can be made in accounting without breaking the rules.

Therein lies a dilemma for investors trying to ascertain a company's financial health by examining its accounts. Mr Fastow noted that while a chief financial officer cannot transform a company's underlying economics, he can transform how it looks to the outside world.

And that was where he had erred as he looked for loopholes and undermined every accounting principle possible to make Enron look like a healthy company when it was not.

Mr Fastow also highlighted other problems such as the widespread use of off-balance sheet vehicles which conceal the risks a company may be experiencing in its business and the controversial practice of "marked to market" approach on prices of assets acquired by companies which are not publicly traded on a stock exchange.

He said: "The accounting rule for 'marked to market' when there is no screen price and no mechanism for price discovery is simply to take the price at whatever the company thinks it is. That is really the rule."

Investors may get a false sense of security, relying on professionals such as accountants and lawyers to play the "gatekeeper" role. He said: "Accountants and attorneys are there to help the company get the job done. They are supposed to protect the company and, yes, they are also supposed to help executives to get the deals done."

To lend credence to his observation, he added: "Every deal I did at Enron was approved by accountants, inside and outside attorneys and the board of directors. You can follow all the rules and commit fraud at the same time."

Still, it is not as though the market is not aware of the problem areas in accounting. In general, the market would give companies a lot of latitude and flexibility to pick the assumptions to do their deals as long as they stay within accepted boundaries.

The tipping point occurs when the market discovers a questionable deal where it feels the company has crossed boundaries. When that happens, the company loses the tacit trust it enjoys in the market which may then want to scrutinise every deal that it had made. That might, in turn, cause a plunge in stock price, as investors lose confidence.

Examples abound. The latest, which appears to fit the bill, is crisis-stricken Canadian drug maker Valeant Pharmaceuticals whose share price had plunged 55 per cent in the past four weeks, wiping US$34 billion (S$48 billion) off its market value, after it was accused by short-seller Citron Research of using speciality pharmacy Philidor to artificially boost its sales.

Before Citron's accusation, few investors had even heard of Philidor. But what perturbed the market was that until its recent plunge, Valeant had not discussed its work with Philidor even though it had been counting Philidor as part of its financial results for almost a year and said it owned an option to buy it.

But Philidor accounted for only 7 per cent of Valeant's third-quarter sales - a case of just one questionable deal casting a long shadow of doubt over the entire company's future.

So what can investors do to avoid buying into a stock that may become a short-seller's target?

Short-sellers claim they are financial detectives, scrutinising companies for purported wrong-doings. They often target companies with weak finances.

The Economist magazine noted that it is far more difficult for firms to fluff up audited cash-flow figures - which measure the cash coming in less the cash paid out - than profits or balance sheet. "Four of the five firms in trouble today have had weak cash flow," it observed.

Other warning flashes include the fiendishly complicated business models adopted by companies which rely on "adjusted" results and "proforma" numbers to dress up their accounts, the high level of debts they are carrying, as well as their propensity to make serial acquisitions.

For investors, the message is clear: If you don't understand the complicated business model of the company whose shares you are buying, it is better to stay out. That may save you a lot of heartache if a short-seller comes knocking on the company's door raising awkward issues.

This article was first published on November 16, 2015.
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