Recently, I’ve posted my thoughts on Gencer (GENC), Addvantage (AEY) and Lakeland (LAKE) (in LAKE’s case, very recently). One thing I found interesting was I got an email on each questioning a potential fraud case, a comment on GENC questioning fraud, and oddballstocks and STreport both mentioned potential for shenanigans at GENC in their write ups.
I thought this was really, really strange, so I thought I’d take the time to discuss why there’s almost no chance these (or most of the companies I mention as longs on this blog) are frauds (note: i’m interchanging fraud with accounting sheningans here. I guess there’s technically a difference, but for me it doesn’t really matter) .
Let’s start with the individuals companies first, and then move on to why it’s going to be pretty tough for me to post a fraud on here. On the individual company side, most of the “fraud” claims center on small balance sheet items. For example, some of the Gencor’s questions focus on their accounts recievables, a ~$6m line item in GENC’s balance sheet. The questions I got on LAKE centered on ~$3m in deferred tax assets. These companies both have ~$100m balance sheets. If either company was committing fraud… I doubt the place to do it would be in those line items. If you suspected fraud, you’d want to investigate GENC’s $70m+ investment account or LAKE and AEY’s inventory accts (by far the biggest items on their balance sheets). (Note on GENC, oddballstock does have some questions related to letters from the SEC and CFO turnover. I don’t have very good answers for the CFO question. I think the SEC letters stem from GENC being a very private public company that consists mainly of investments. The SEC tends to watch these closely to make sure they aren’t actually publicly traded investment companies)
The second reason I doubt there’s anything fishy going on is because these company’s performance is currently horrendous. If you were going to commit fraud… wouldn’t you at least show decent performance??? LAKE and AEY both have positive earnings, but their ROE’s are horrendous and their sales are flat or declining. AEY’s performance has been steadily falling for the last five years. Both management’s have expressed frustrations with their performance. Gencor doesn’t really talk much, but their operating business has been cyclical and, quite frankly, crappy for years. They haven’t done anything to try to hide this fact. If anything, they’ve tried to make it worse by over depreciating assets. Frauds tend to show consistent and steady increases in performance in order to gain enthusiasm for their stocks. Nothing to see here.
Next, frauds tend to constantly change accountants. GENC’s had the same accountant (MSL) since emerging from bankruptcy 10 years ago. AEY has been served by HoganTaylor or one of its predecessors for ten years as well. LAKE is the most questionable here, having switched from PWC to one firm in 2005 and then to their current firm (Warren Averett) in 2010, but given no other real red flags of fraud, I’m willing to give them the benefit of the doubt. All these accounting firms are relatively large, reputable firms with a pretty long history, which lends a bit more credibility to the numbers.
Finally, none of these companies are promotional. The purpose of fraud is (in general) to trade for a sky high multiple so you can issue lots of shares at high prices, juice the value of your stock options, and retire to a beach. All of these companies are managed by managers with long term stakes in the company (insider ownership over 20% in each company) who haven’t sold a share in years. Management pay might be a tad on the high side (I think they’re reasonable, especially considering what mgmt brings in terms of long term experience), but there are no red flags here. Management isn’t out there promoting these stocks or trying to attract momentum players to drive the multiple up. Again- if these were frauds…. what’s the point??? What benefit is management getting by risking jail time and family humiliation to perpetrate fraud here???
And that brings me to why I doubt any frauds are going to make it on to this site. The stocks I deal with generally trade at large discounts to assets and/or long term earnings. They have high insider ownership and long operating histories. They’re unknown and unloved. Frauds tend to have the exact opposite characteristics. The stocks I deal with aren’t acquisitive, and if they have done acquisitions it generally isn’t with shares and are extremely small acquisitions. Frauds tend to be incredibly acquisitive, as acquisitions allow them to play around with their accounting and goose up growth rates. And speaking of acquisitions, frauds love to use shares to acquire companies. The easiest way to get me to avoid a company is to have a history of share issuance.
In sum, frauds tend to be promotional, extremely acquisitive, issue shares left and right, have short histories filled with constant and consistent growth, and normally out of this world returns on capital or growth rates. The companies I deal with have none of these things; they actually tend to be the exact opposite. So simply by using a deep value frame work when searching for companies, I (and by extension, this blog) will tend to avoid frauds.
Or so I hope!
Disclosure- Long AEY, GENC, LAKE
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