How to Identify A Fraud Stock by Asking Just 5 Questions

Between June 2003 and June 2020, the annual churn rate of the BSE 500 index was about 12%.

This means about 60 companies were knocked off the index and were replaced with other companies every year.

Out of the companies that were shown their way out of the index, many of them were involved in fraudulent transactions and had shady governance policies.

These companies wiped out investors' wealth on their way out.

The legendary investor Warren Buffett, had commented on how easy it is for companies to steal money these days.

Here Buffett on fraud companies:

"It has been safer to steal a large sum with a pen than a small sum with a gun."

Thus, if an investor wishes to create wealth by investing in stocks, avoiding dubious companies is as important as choosing great companies.

But how do you identify a fraud company?

By seeking answers to some critical questions. In this article, we share with you five critical questions that can help you identify a fraud company.

These five questions are inspired by a book, "Diamonds in the Dust."

#1 Do other financial statements paint the same story as the P&L does?

This is an important question, given that we are so obsessed with the P&L statement.

The P&L statement is just a snapshot of a company's sales, expenses, and profits. It doesn't give any information about the cash flows or debt on books.

Thus, viewing the P&L statement in isolation would give a skewed image of a company's financial well-being. Investing based on this skewed image isn't a wise move.

Investors must analyse all three financial statements holistically to get the true picture.

The next time you analyse a company, look beyond the P&L statement. If you come across an impressive P&L statement, check if the other financial statements paint the same story as the P&L does.

You can start by reading the cash flow statement and checking the company's cash flow from operations (CFO) for the last five years.

If the CFO is negative, you must stay away from the company.

However, if the CFO is positive, check what percentage of the operating profit or EBITDA it is. If it's less than the industry median, that's a red flag too.

#2 Are the majority members on the company's board friends or relatives of the promoter?

A company's board of directors make crucial decisions concerning dividends, mergers, acquisitions, and the appointment of high-level executives.

It also frames the governing policies of a company. Therefore, a company can't afford to have a weak board of directors.

What do I mean by a "weak" board?

A weak board is one where all the directors are somehow related to the promoter. They are either friends or relatives of the promoter. In such a case, the promoter is an influential person on the board and drives the show.

Ideally, the board of directors must have a healthy mix of insider directors and independent directors.

Independent directors are not associated with the company in any capacity. Thus, they subdue the influence of the promoter and ensure the decisions are not the result of one man's whims.

Through their active participation in decision-making, independent directors ensure the company doesn't engage in unethical practices.

Independent directors also bring a diverse perspective to the company's board. This helps a company score high on corporate governance.

However, independent directors are a bottleneck for fraudulent companies. They are a hindrance to the promoter's attempt to siphon off money.

Thus, a weak board is a common characteristic among fraudulent companies.

So, the next time you analyse a company, check who all are on the board and if they are related to the promoter.

#3 What is the company's total transactional value with related parties? What is the percentage of related party transactions to the total revenue?

The company you are analyzing could be a part of a larger group. An example is Cholamandalam Finance, which belongs to the Murugappa group of companies.

If Cholamandalam Finance transacts with other group companies, such transactions are known as related party transactions.

It's normal for group companies to engage in such transactions if the transactional value isn't substantial.

However, if the total transactional value constitutes a sizeable portion of the company's total revenue, that should catch your attention immediately.

Many fraudulent companies transact with related parties to inflate their revenue, profits, and assets.

Let me tell you about a fraudulent company that pulled this trickery seamlessly.

Cox & Kings India, once a travel giant, filed for bankruptcy in 2020.

Upon investigation, it was revealed the company transacted with related parties frequently. These transactions helped the company to inflate its revenue and profits.

As per the last annual report published by the company, revenue from related parties accounted for 92% of the company's total revenue.

On top of that, the company lent massive amounts to promoter-owned entities.

Also, the terms of transactions were detrimental to the company. The terms were such that the company's debtor days averaged a whopping 148 days.

That's unusual for a travel company where people pay for their trips in advance.

This example serves a clear message. Keep a close eye on related party transactions. It helps you distinguish fraudulent companies from genuine ones.

#4 Is the gross block turnover of the company sub-par when compared to the industry average?

Another way to determine if the company is faking its robust revenue growth is to compare its gross block turnover with the industry median.

The gross block is the total value of all fixed assets such as land, buildings, machinery, and manufacturing plants.

Gross block turnover is total revenue divided by gross block. It's a measure of a company's efficiency to generate revenue from its fixed assets.

An investor must tread with caution if a company grows its revenue faster than its peers but has the lowest gross block turnover in the industry.

Going back to our Cox & Kings (C&K) example, the company had an average gross block turnover of 3.1x between FY16 and FY18.

As against this, MakeMyTrip's, one of C&K's peers, gross block turnover averaged significantly higher, at 9.7x during the same period.

C&K India's low gross block turnover didn't complement its robust revenue growth reflecting its fraudulent practices.

#5 Is the auditor's remuneration growing faster than the company's revenue?

If the answer to the above question is yes, that's a clear red flag.

Think about it. The company is incentivising its auditor to certify its inflated numbers.

In most cases, you would observe such incidents involving small and relatively unknown auditing firms. However, that is not an absolute truth.

There have been instances where large auditing firms were involved in fraud.

For example, in the infamous Satyam scam, Price Waterhouse certified the mis-stated accounts of the company. However, such incidents are rare.

Generally, large and well-known auditing firms would not get involved in fraudulent practices as their reputation is at stake.

Having said that, an investor must seek the answer to the above question, irrespective of who the auditors are.

This will prevent investors from falling for fraudulent companies.

Some tips on keeping fraudulent companies at bay...

In some cases, it becomes really difficult to spot a fraudulent company due to creative accounting.

However, in most cases, it's possible to unearth a fraudulent company if you are willing to spend some time reviewing the books of accounts and reading annual reports.

The questions discussed above would come in handy and expedite the process of identifying a fraudulent company.

Besides, there are a few other pointers investors must make a note of.

First, let's talk about acquisitions. An investor must check if the company is taking on debt to pay for its acquisition. If yes, be extremely cautious.

Second, investors must analyse all listed promoter-owned entities and their overall holding structure. If it's too complex and you are having a tough time understanding it, better to stay away.

Another thing to keep a check on is if there are any inconsistencies in financial reporting. If affirmative, forget everything you may know about the company.

Keep a close watch on the management's salary. If you notice a large divergence between management's salary and the company's fortunes, well that's a problem.

It shouldn't be the case where top level executive are living a lavish lifestyle while the company is suffering from high debt.

The company might not be paying dividends despite robust free cash flow. Look for the reason as to why the company is doing so. If it doesn't make sense to you, something's not right.

Last but not the least, beware of the resignation spree. If top-level executives and board members are on a resignation spree, that's a matter of grave concern.

That's it for this article. If you like our content, let us know by dropping a comment below.

Until next time...

Happy Investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.