Two ways to spot dodgy directors

published 23 November 2010

As I write this, all eyes are on Ireland. Another weekend and another patch-up.

I have long-since suspected that we've not seen the end of this financial crisis. Businesses are failing week in, week out; and behind the scenes company executives and directors are scrambling to patch up their businesses too.

Let's cut to the chase: some of these people are no better than criminals. And their plotting and scheming could destroy your investment.

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Today I want to show you two ways that dodgy company executives conceal their crimes and how you can avoid falling into their lair.

Whodunnit?

Agatha Christie mastered the art of suspense by the way she created layer upon layer of complexity in her plots. She keeps the criminal tantalisingly close, daring you to guess the culprit before the final show-down.

Corporate dramas can be much the same. Investors are left to guess the identity of dodgy company executives that conceal the truth within a labyrinth of complex accounting.

Dodgy directors use the accounts to deceive. By creating layers of complexity, they conceal where the bodies are buried.

I'm not just talking about companies like WorldCom, Enron, or the Madoff empire. For every one of those big name cases, there are dozens of less well-known firms that fail and bring down shareholders every week.

The culprits create layers of complexity using things like 'special purpose vehicles' (SPVs) and subsidiary companies to shift assets between different balance sheets. They open derivative contracts, and shift money around accounts (and countries) so you can't see what's happening. They create bond holdings, share options and special share classes to confuse the ownership and debts.

The accounting tricks are many. Of course, the regulators aim to close down bogus practices, but when you've got a dishonest executive, it's incredibly difficult to find them out.

There are, however, a few telling signals to watch out for.

How you can avoid nasty surprises

We rely heavily on City analysts to unearth dodgy companies, but in practice analysts are a poor substitute for Chrisitie's Poirot...

Frankly, the accounts of many companies are so complicated that even the CEO can be hoodwinked by a shrewd finance director.

But I'm always suspicious when the chief financial officer (CFO) leaves a company. I wonder if there's an accounting black-hole bubbling away under the surface. I wonder if the CFO is making a break for freedom before the day of reckoning.

I also prefer to stick to companies with simple corporate structures.

I get loads of accounts through the post, but most go straight in the bin. The ones I keep and consider for investment are the ones that I can get a grip on over my bowl of cornflakes and cup of coffee.

If I need to sacrifice half a day (or more) then I start to get nervous. And believe me, complicated accounts can take days to get through. The deeper I delve, the more hiding places I see and the more suspicious I get.

If the notes to the accounts stretch to tens, or even hundreds of pages, paranoia starts to creep in. I'm looking for simple accounts that are intelligible straight off the top. And I'm not just talking about the numbers here.

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Don't get bamboozled by accountingese'

In the same way that I hate legalese (the jargony words of the legal profession), I hate 'accountingese' - expressions that sound positive, but in reality are meaningless, or worse.

I used to look forward to reading the bit of the accounts titled 'Future outlook' but now I'm almost always disappointed. The same stuff comes out nearly every time: "despite the difficult economic environment, your company looks forward to the future..." Let me just translate what that means: "Blah, blah, nothing, blah blah." It doesn't tell us anything at all.

In fact, most company accounts are full of this tosh. If it's ladled on too thick, it goes in the bin. Why?

Well I can't name names. But I've held stocks in the past that have gone belly-up because directors hid stuff between the layers. And when I looked back at the accounts to try to find out where I had gone wrong, I noticed something. In these bust businesses, I saw the same old tosh as I went through the old accounts.

The tell-tale signs were there, legalese and accoutingese with the simple aim of deceiving and covering the backs of directors.

Look out for these two things:

First, look for simple accounts. Make sure you can see what's going on straight off.

Second, look for companies with directors that speak in a normal and candid way.

When it comes to investment, I don't want to be a super-sleuth. I don't want to have to spend time looking for the bodies - I'm looking for investments where I feel confident that there aren't any.

This article was first published in the free investment email The Right side. Sign up to TheRightSide here.

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Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.

He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.

Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.