One of an investor’s worst nightmares is to find that a company you’ve invested in is involved in some sort of accounting scandal. It’s a disaster for the share price, obviously. Worse still, it pulls the rug out from under you.
Whatever your rationale for owning the stock, the idea that its numbers might be flawed or even fictitious, means you have no way of judging just how bad the situation is. How can you minimise the odds of this happening to you?
Let’s take a look at a currently erupting German scandal to find out what we can learn.
Start your trial of MoneyWeek today
Get unparalleled financial insight, analysis and expert opinion you can profit from.
Start your trial
Sign up for MoneyWeek’s free twice-daily newsletter.
Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.
Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.
How Wirecard blew up
Wirecard isn’t a stock I paid much attention to, but I do hope none of you owned it (either on your own account or – more likely – via a fund manager such as Alexander Darwall, who had a very big holding in the company until a few days ago).
Latest Videos FromMoneyWeek
I’ll give you a potted history here. Wirecard is a German payments processing company. In 2018, it joined the Dax index (the German equivalent of the FTSE 100).
There have been questions about Wirecard for years. In 2016 it took a kicking as short sellers targeted it over the quality of its financial controls. In October 2018, an FT headline read: “Wirecard’s meteoric rise prompts questions”. It included quotes from more than one analyst questioning exactly where its growth was coming from.
But things really kicked off early last year when FT investigative journalist Dan McCrum really started digging into the story. He and his colleague Stefania Palma published a number of stories using reports from whistleblowers inside the company that suggested various elements of internal accounting were dodgy.
Wirecard promptly sued the FT and the reporter. Not only that, but Bafin (the German financial watchdog, their equivalent of our FCA) also immediately closed ranks. It banned short-selling of the stock, exuding a general sense that an innocent German company was under attack by nasty Anglo-Saxon corporate raiders, and – quite extraordinarily – it also filed a complaint against the journalists.
However, despite the bluster, the suspicions put more scrutiny on the company’s already-opaque accounting. A special audit by KPMG was commissioned by Wirecard. This was meant to put any qualms to rest.
Instead, when it released its findings in April, it turned out that KPMG had been unable to get hold of key documents. There were no accusations of manipulation – but the audit certainly didn’t give the impression of a company with strong internal controls.
Then, last Thursday, we got the big bombshell. The company’s regular auditor – EY – said that it couldn’t find €1.9bn in cash that the company claimed to have. On Friday, CEO Markus Braun stepped down. Yesterday, Wirecard confirmed that the cash probably does “not exist”. And this morning, Braun has been arrested.
Shares in the company have fallen by more than 80% in the last week. I’m not sure what’s going on in the heads of anyone who still owns said shares, but I wouldn’t be recommending you pile in, put it that way.
Always remember that a share that has already fallen in value by 80% can still fall in value by a further 100%.
Three lessons to learn from this debacle
OK, so what can you learn from this? There are three key points I have to make, and the nice thing is, they’re all really simple.
1. Always understand what you are buying
You should understand how the business model of any company you invest in works. How does it make money? How does it grow? How does A connect to B connect to C?
Yes, tech stocks are exciting. But if you don’t know how they make money – and I’m including the likes of Apple and Google here – then you have no business owning them.
I’m not saying that you have to get forensic here. But this is why individual stock-picking is hard. If you’re going to do it, then you have to be willing to do the work – or accept that you’re gambling.
If you are investing via a fund, you don’t have to do the same level of due diligence because you assume the manager is doing it. However, as we’ve seen, that may not always work out.
So take a similar approach – the most successful fund managers that I’ve seen have a very clear strategy and are able to communicate it equally clearly to their investors. If you don’t understand a fund manager’s strategy – in effect, if you don’t understand how he or she intends to make money for you both – then don’t invest with them.
2. With companies, assume that where there’s smoke, there’s fire
When it comes to individuals, I agree that it’s best to err on the side of “innocent until proven guilty”. But when it comes to companies and protecting your money – be as suspicious as you like.
Here’s why: short-selling is a thankless task – markets go up most of the time, so you’re fighting against the tide. Everyone hates you. Longs hate you. Regulators hate you. Even people who sympathise think you’re a little bit weird – moral crusading plus massive financial bets do not make comfortable bedfellows.
And thank goodness. Because it’s all this hatred that makes short sellers a great warning sign. If shorts are so convinced of their case that they are willing to face down all that hatred, then they are worth paying attention to.
Shorts aren’t always right, but they are usually good enough to lay out their thesis so that the company can challenge it. So watch the reaction. If the company takes the case on board and then refutes it with clear explanations, that’s good. Netflix CEO Reed Hastings did a good job of this back in 2010, with short seller Whitney Tilson.
If the company instead goes hostile, starts shrieking about the media, and better yet, has a regulator onside (this is unusual, to be fair – the FCA and the SEC are hardly dynamic but I can’t recall them pulling anything directly comparable to this), then watch out.
And in this case, the smoke was positively billowing from the company, for literally years. As well-known fund manager Barry Norris – who was shorting the company for several years – told Citywire a couple of days ago, Wirecard “waved more red flags than you might witness at a communist rally”.
3. Show me the hard cash
Cash is king. It’s the hardest bit of the accounts to manipulate. In most of the big scandals or plain old disasters of recent years, the problems have come about when companies have (mostly legally) claimed to have made profits that they didn’t in fact have at all, via tricky accounting practices such as recognising revenues at very early stages in the sales process and the like.
It’s a wide and varied area to cover and we have lots of material in MoneyWeek on various aspects of accounting (get your first six issues free here if you don’t already subscribe). Tim Steer’s excellent book, “The Signs Were There”, goes into a lot of detail on many of these points. But my main point is this – it again comes back to a need to understand what is going on with a business before you invest in it.
Now, there will always be exceptions to these rules (Tesla is an obvious current example which may or may not prove to be an exception in the long run).
And I’m not saying that you can spot or avoid every bad experience. Patisserie Valerie is a rare recent example of a business that wasn’t very hard to understand, but which still fooled its investors (and the red flags were not at all obvious beforehand).
But if you understand what you are buying, and you pay attention to any serious critiques, then you should be able to avoid the worst.
And always remember. You are a small investor. You don’t manage money for anyone else and you don’t have to justify the whopping great bet you’ve taken to your boss or your investors at any point. If you’ve screwed up, then get out. It’s better to lose half your money than all of it.
