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Though not by fault of the embattled multilevel marketer Herbalife (NYSE: HLF ) , the company's auditor, KPMG, is under fire from regulators and investors alike after a trading scandal exposed a partner in the firm giving insider information to a third party. While the incident alone is not representative of the firm as a whole, or the accounting industry in general, it should serve as a reminder to investors that auditors are not always our friends, and at the end of the day, the companies they review are the ones writing the checks.
A few years back, I was one of the masses knee-deep in Chinese small and midsize companies. Investors likely know the story by now, but the short version is that these were companies with triple- and quadruple-digit growth trading at insanely low multiples. The opportunities drew in small retail investors and hedge fund titans alike -- including John Paulson. Then, many of these "no-brainers" turned out to be frauds -- or at least extremely sketchy companies -- and money was lost nearly across the board.
Now, this was not the result of any one factor, but one thing I noticed among my fellow investors was blind faith in the larger auditors. One of the early criteria for "weeding out the bad" was for the company to hold down a Big Four auditor: KPMG, Ernst & Young, Deloitte, or PWC. According to that logic, one of these reputable firms would always act in the interest of shareholders and the public -- finding inconsistencies, reporting errors, and resigning if the company refused to change.
The thing is, that isn't exactly how it played out.
Several Chinese small caps, including some much-beloved stocks that investors piled into at first, were audited by the majors. Only later were those companies determined to have inflated results, misrepresented clients, and even outright lied. Investors lost millions in the process.
In December of last year, the SEC took measures to crack down, threatening to deregister the Chinese affiliates of the Big Four if they did not comply with SEC rules (which also contradicted with Chinese regulator rules, adding to the headache).
The issues have hit closer to home as well, with many questioning why the Big Four did not pick up on any of the issues facing the major banks in the days before the financial crisis. If a variety of fund managers and economists were able to pick up on their impending troubles, why couldn't the auditors who were staring at the financial statements day in and day out? Was it the fact that the auditors' business is contingent upon big checks from the clients they are hired to review?
This latest issue is not as systemic -- it was just one partner doing something very stupid. It has cost KPMG two major clients so far, Herbalife and Skechers (NYSE: SKX ) , but more important, it adds to the sullied reputations these firms are earning.
The takeaway for investors is: Keep a watchful eye on financial statements, and don't let the Yahoo! Finance page be the end of your due diligence. Talk to competitors, talk to management, and even visit the sites, if possible. One way my previous employer discovered a fraudulent Chinese firm was by camping outside of the manufacturing plant -- where trucks should have been pouring out like freshly mixed concrete. The trouble was, no one was coming in and out. It was a dormant factory, contradicting what the company's financial statements and press releases said about the facility.
In the world of investing, there is truly only one person firmly in your corner: you. Don't let that fact become an after-the-matter lesson.
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