19 December 2008

Getting It Wrong

This week I am going to share some ideas that will, hopefully, save you from a large financial loss at some stage in your life. Over the course of your life people will steal from, mislead and generally attempt to swindle you -- if you hit 50 and think that this has never happened to you then you might not have been paying attention!  

Skill-based, achievable, wealth creation stems from two principles:
  • Spend less than you earn; and
  • Protect existing capital.
If you do those two points consistently then your net worth will rise over time.  Sounds easy but it is seldom done effectively.  There are always temptations to cut corners.

Due diligence is time consuming and not much fun -- as such, when I was the new guy at my firm, I got to do quite a bit of leg work checking out potential companies/management teams.  

After a couple quick announcements, I will explain what I learned...

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Tucson and Boulder Training Camps - - we are happy to announce that both of these camp will qualify for USA Triathlon coaching education credit.  Each camp will earn 10 CEUs (the max possible from a single event).  Contact me for more info on Tucson (April) and Boulder (July).  Boulder's dates have been shifted to a Wed-Sun format to better serve working athletes.

Endurance Corner Coaching -- I will be launching an on-line coaching platform in early 2009.  Cost is $25 per week, with discounts if you sign up for a year.  Key differentiator is direct daily access to me, and the EC team.  Specific details in my January 2nd blog.

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Why do research?
Sophisticated investors research companies/management team to reduce losses, not increase gains. 

Promoters do an excellent job of explaining how you are going to make a fortune investing with them. What people rarely do is point out the ways that you can lose money as well as items in their backgrounds that make them high risk business partners.

When you think about the scale of the Madoff scheme ($50 Billion) what comes to mind?  For me, the crime is not the main issue.  What concerns me is the implication for the global economy in 2009.

In 2005, I read Fooled by Randomness and had an epiphany reading Taleb's chapter on Black Swans.  At that time, by way of a personal guarantee, I had over 100% of my assets exposed to a single entity.  The business was run by a trusted friend but my financial health couldn't withstand a Black Swan, so I sold down my exposure.

The lesson we are reminded of with Madoff is that we can all get it wrong.  How does Madoff happen?  Ponzi schemes happen when we allow personal greed and social pressures to cause us to ignore basic investment principles.

Diversification makes the most sense to protect from the unexpected, not to enhance returns.  Right now, I have a 60% exposure to a single bank.  Over the next year, I will be reducing that exposure -- not because I don't trust the bank, rather because the impact of getting it wrong would be too painful.

In terms of the unexpected, fraud is probably #1.  Fraud hits you in multiple ways -- loss of money; loss of time; and risk of reputation.

While it's tempting to focus on financial losses, the money is normally gone by the time you figure out that you've been ripped off.  Pursuing business crime makes sense (and is essential) to help protect future victims, rather than recover assets for existing victims.

I suspect that business crime is going to explode in 2009 -- not because more of it is happening... rather... it will become apparent as the Great Unwinding continues.

Things you can do to limit your exposure to business crime:

Ask questions -- we have an inbuilt inhibition to ask questions in rising markets and public forums (this is one area where I support anonymous posting).  Fraudsters will take advantage of this shared trait -- read Influence, it will save you money.

This Word file link is a mild form of private equity questionnaire but covers the main issues that have cost me money over the years.  If you are using Safari/Mac then click here for an HTML version.

Be willing to walk -- if you get a bad reference then walk from the deal.  Even with this policy, you will make mistakes but you'll make less of them (and that will make you money in the long run).  By paying attention to red flags before investing you will save time, money and protect your reputation.  

From a portfolio point of view, it is a lot more important (and easier) to dump your Enrons, than find your Microsofts.

Get inside -- if you are investing 10%+ of your net worth in a project, or company, then get inside so that you have superior information.  If you can't get inside then don't invest.  VC and Private Equity firms have known this "secret" for years.  

The two main sources of private equity return are leverage and superior information.  Trouble is, as an asset class, the insiders scoop the excess return for themselves.  As well, even the insiders don't know which deals/funds are going to be winners.  They use the same rules -- check up-front & limit losses.  To that the professionals add: maximize financial engineering and access superior information.

Speak to the auditors -- again, sounds simple but it doesn't get done enough.  When you speak with the auditors -- do it independently, without management and speak with the accountant that did the work (not the partner in charge).  

Questions to ask:
  1. Tell me one thing that you found that concerned you.
  2. What was your materiality threshold?
  3. Did you tie all invoices to bank statements for everything above your threshold?
  4. What connected party transactions did you discover?
  5. Did you reconcile large payments to contractual documentation?
  6. Did you reconcile large payments to an approved budget?
  7. What is the approval/payment procedure for large transactions?
  8. Which transactions were paid outside of the normal approval/payment procedures?
Question #1 is a good way to form questions -- people are extremely reluctant to give negative feedback.  So you ask them directly, but for "only one" point.  That opens them up and gets the conversation going.

Write your notes of that meeting up and send them to the partner in charge of the account -- for their file and your own.  The partner will likely come back an tell you that answering all this information was outside of the scope of their work.  Insist on having the work done -- again, it will save you money over the long run.  

If management get upset then assume they have something to hide (it will save you money in the long run...).

The Gipper summed it up best.  Trust but verify.

Maybe Obama will come up with some energizing slogans for what is going to be a very challenging new year.

Back next week,
gordo

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3 Comments:

At 11:12 AM, Blogger Laurie said...

One thing to keep in mind: there has always been a fairly wide gap between the public (users of the financials) expectation of what an audit includes and what it actually includes. The biggest area of misconception is often around the auditor's responsibility to discover fraud. While the professional standards have evolved (especially in recent years), the primary function of the audit remains to determine whether the financials are free from material misstatement. Additionally, when you get more than one person perpetrating the fraud (collusion), the chances of discovering it are significantly reduced.

 
At 6:25 PM, Blogger Bruce Stewart (施樸樂) (ブルース・スチュワート) said...

This kind of post should be essential reading in a mandatory course in basis life skills. I have been discussing several of the concepts with one of our pre-college sons. For me it is a good reminder. I have audited companies' books in the past. Of course, financial statements (due to the assumptions used, disclosure requirements or lack of them, whether intangibles are accounted for, etc.) have their limitations, but this surely provides all the more reason to focus on due diligence, rather than place increasing reliance on the promoters, who certainly appear to be more influential than their more conservative counterparts in the accounting profession.

 
At 7:12 AM, Blogger Mike M said...

This is a very timely topic for me as I am beginning to question an investment that I made in private equity. I will do some things differently next time.

Thank you for sharing your thoughts!

 

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