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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good article, your arguments make sense.
happy holidays!!
regards
rijk
I totally agree that it doesn’t make sense for these companies to be a fraud, but I don’t think that just being a value investor is enough to avoid frauds. When the market is starting to get skeptical of the numbers reported by a company they can become very cheap on almost all value metrics. Think you should always consider the possibility and decide if it would make sense or not.
Hi Hielko,
I certainly agree with you. The point was more the companies I discuss are so cheap and their financial metrics are so poor that, if management was trying to perpetrate fraud, they’d be doing it wrong!!!
Interesting post, I don’t think it’s exactly as clear cut as you make it. There are a lot of companies that are aggressive with earnings that aren’t stock printing penny frauds. There’s actually a very clear distinction between the two, I don’t think either of these companies are fraudulent. Even most of the China RTO “fraud” companies had real businesses doing real things. A total fraud is something like a boiler room stock.
I think there’s actually a big different in AEY and GENC. I think AEY’s problems are structural, all related to their business environment and their strategy. I don’t remember questioning AEY’s accounting when I looked into them. Maybe there is an inventory write-down lurking, but that would be it.
With GENC they are extremely aggressive with their accounting, this isn’t something that’s open to interpretation. If you review all public companies GENC is in the upper quartile with how they account for things. The investor needs to decide if this is important to them or not. I recognize that $3m out of $100m seems like chump change but it brings back the old expression “never trust an exec who takes a mulligan”, I think the same principle applies.
I think the bigger problem with GENC is that management’s strategy is at odds with the goal of a value investor. A value investor is buying the investments and gets the business for “free”, this thesis rests on the idea that management won’t squander the cash. I did some Googling on the GENC CEO and he’s been very vocal about the idea that he intends to use the cash hoard to acquire other businesses. They intend to become a $500m company by acquiring their way up there. Even if all of the accounting can be explained away (which I would argue it can’t) the fact that the margin of safety is going to be used to buy another business doesn’t exactly give me the warm fuzzies. Just a general note as well, often companies will use acquisitions to hide accounting shenanigans.
You seem to have received a really good response on the GENC article as best as I can tell. I have no horse in this race, but I’m just very concerned about what I’ve seen and I feel that other investors need to be aware of the issues. You seem to have peace with them which is fine, I just want to provide visibility. I recognize that not all value guys, or even net-net guys will agree all of the time.
I enjoy the blog, hopefully this doesn’t come off as pointed or judgmental or anything, I’m hoping to be informative. I also believe in the phrase that “iron sharpens iron”, your perspective has helped me rethink my own positions as well.
No offense taken at all- the fraud comments on AEY and LAKE were from reader’s emails.
I don’t think there aren’t some strange things, though I don’t think a company w/ $11m in fully depreciated assets currently in us (more than 10%) is a super aggressive concern.
The real reason I think I’m safe here is, as I said, is there’s really no incentive for fraud. GENC doesn’t tap the capital market. Their CEO founded the company 50 years ago, owns the majority of the stock and hasn’t sold a share in years. Their business performance is crappy. They’re not really trying to hide that. So what is the purpose of fraud here???
I think the answer to all of your questions can be answered by this simple explanation- the CEO is an egomaniac who dominates the company. Is that a valid reason for not investing in them? Definitely. I think I’m well protected by the significant discount in assets, but I’ve certainly passed on similar companies in the past.
Ok, I hate to post again, but I dug in further. I guess this sort of thing attracts me, so I’m just wondering how you resolved the following:
1) The company reports changes in marketable securities as operating cash flow. In addition they report their acquisition and sales of marketable securities as operating cash flow. GENC is not a financial company so I’m not sure how this is valid GAAP accounting. This should be investing cash flow.
2) The difference in carrying value for the investment portfolio only fell $841k between 2010 and 2011 yet there is a $2.553m change in marketable securities value in the cash flow statement. I can’t reconcile this, so either the cash flow is misstated or the carrying value is incorrect.
3) There was a class action lawsuit back in 1999 alleging securities fraud and financial misstatements. The current management was in place back then. The lawsuit was settled but there is a lot of information in the dockets alleging the same sort of behavior we’re discussing on the blogs here. At the very least this sort of questionable stuff has been going back more than a decade.
4) The public accountant didn’t review any of managements controls this past fiscal year.
I also found another blog post detailing a lot more questionable items, it might be of interest: http://tfideas.blogspot.com/2010/10/is-gencor-accounting-fraud.html
Anyways, I’d be interested to know how you reconciled these issues when researching.
I’m late to comment here but thought I’d put in my 2 cents. I think your reasoning is pretty good here, except that I wouldn’t take anything from a long standing auditor relationship.
I used to work as a lawyer defending auditors in securities fraud cases. Audits are simply not very good at rooting out fraud. Auditors have to rely far too much on the representations of management, and any company that will lie to its investors will lie to its auditors. Even an audit conducted competently and according to all professional standards can miss the signs of a fraud, and in many cases the auditors are less than competent. This is true whether the firm is large or small, has a sterling reputation or none to speak of.
A change of auditors can be a yellow flag, and if it comes via auditor resignation while they are working on the annual report consider it a blazing red flag. But the fact that there is a longstanding relationship there should not be taken as any comfort there is no fraud. After all, Madoff had the same auditor for almost 20 years and was with the same firm for longer than that. Enron had a longstanding relationship with Arthur Andersen. In most cases, the auditors learn about the fraud when the market does.
Excellent points here Greg, thanks for the input