Finanical Fraud and International Companies

In this episode of Industry Focus: Wildcard, Emily Flippen and Motley Fool analyst Bill Mann talk about financial fraud in the international space. They look at the example of Luckin Coffee (LKNC.Y -2.31%), giving insight into the challenges of researching foreign companies, some hints on spotting discrepancies, and a look at whether you should worry about investing in foreign companies.

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This video was recorded on May 20, 2020.

Emily Flippen: It's Wednesday, May 20^th, and I'm your host Emily Flippen. For this Wild Card Wednesday, we are once again joined by the timid and soft-spoken, Bill Mann. [laughs] Bill, thank you for joining us again.

Bill Mann: Are my levels OK? [laughs]

Flippen: Your levels are great, Bill. [laughs]

Mann: You know, it's funny, when we first started doing Motley Fool Live, I was having audio problems and people kept saying, "Bill, you're too quiet." I was like, I have never, ever in my entire life been accused of being too quiet. But here we are.

Flippen: Yeah, I love running that joke, because we had just started filming this right after we filmed last month Wild Card Wednesday deep dive into international investing with you, Bill. And your first response to me afterwards, "Was that OK, did I talk too much?" It's always great with you, Bill, because you're never afraid to take a question and roll with it, even if it means getting into a long conversation about salmon; it's great.

Mann: [laughs] It was a great conversation.

Flippen: [laughs] Well, we kind of left the listeners last month on a cliffhanger there, tease them a little bit with Luckin Coffee and fraud that might exist in the international space, so I love to take the next 10, 20 minutes or so and talk about the financial fraud that we've seen over the past few months. In particular, how it's affected international companies. Obviously, Luckin Coffee is the easiest one to talk about, and they really dropped the ball, as you alluded to, in our previous call when they admitted that some of the claims in the short-seller report were actually accurate that they had been, in a sense, defrauding investors.

So, how do you feel about that? How do you make sense of this news?

Mann: Well, I feel sad. So, when we do our process here at The Motley Fool; and that is actually, it was, we actually sold the instant this news came out as quickly as we could in Luckin Coffee. Essentially what had happened was that a short-seller named Carson Block, who works at Muddy Waters came out with an unattributed report that said that there were revenues that were being fabricated at Luckin Coffee. Luckin Coffee has thousands of coffee shops throughout China and it is a legitimate real business. I have had Luckin Coffee before; it's a real place.

But someone did a tremendous amount of research and found that the revenues that the company was claiming couldn't possibly be what the company said. And the company came out and said, no, that's not correct and here's why. And then on April 2^nd, they disclosed in a 6-K, which is a filing that foreign companies use to the Securities and Exchange Commission saying, yes, actually, our Chief Operating Officer and some other now fired employees of the company were fabricating revenues of RMB 1 billion, Chinese currency, so about $310 million worth over three quarters at Luckin Coffee, which was close to 70% of the revenues.

So, this was awful, the stock immediately dropped some-80%. And a lot of people immediately said, I remember what happened with Chinese companies in the last decade, they were all rip-offs, here we are again, and I'm done with Chinese companies, I'm going to be done.

Flippen: And I'm assuming that's not the mindset that you've taken as a result of this?

Mann: No, it's not. In fact, in some ways I am heartened a little bit by the fact that Luckin Coffee -- I mean, I'm not heartened, that is a very, very, very expansive term for how I feel about this, but the fact that they actually came out with a filing to the SEC is different, it's better than what happened over the last decade.

In 2006-2007, hundreds of small cap Chinese companies came public in the U.S. through a process called a reverse merger into a shell, which would mean, they would find some company that had no revenues, no operations, but had a ticker symbol and they would merge with it. And sis-boom-bah, they are a publicly traded company, because when you merge with a publicly traded company, you can become a publicly traded company. And that prevented them from having to go through a disclosure process before they held an IPO. They didn't have an IPO, they just bought into a shell.

So, when these companies were found to not be what they said they were, this is in 2006-2007, the Chinese government limited foreign auditor access to these companies, limited foreign access to their version of the SEC, their Chinese filings, which were completely off. It was a form, and I say this with some caution, it was state-sponsored theft.

In this case, Luckin Coffee came out and they have no sponsorship from the Chinese government, and they came out and said, yes, we have a problem and it's a huge one and this is what we're doing and we're going to try and make it better. And it's simply a different environment, it doesn't excuse the fraud, but it does give me some hope that it's being taken seriously, that this is not yet another like, you know, we're just going to rip the faces off of the naïve American investors that we've seen in the past.

Flippen: Of course. And you alluded to the short-seller report that was released on Luckin before all of this information came to light and was announced by the company. And you, kind of, understated the research that they did. Part of the research -- I mean, calling it research is a broad word, but essentially one of the things that they had done in this report or claimed to have done in this report, included sitting in on tens of hundreds of stores and quite literally counting the number of people and the number of drinks that were ordered and then essentially using that as a sample size to calculate what they projected to be a fair number of sales and having that number be dramatically off than what the number the company was reporting.

So, I guess the question I have for you is, short of deciding that you're going to fly to China and sit and count hundreds of coffees being sold in stores, is there really any way that this fraud or any fraud out of foreign companies can be spotted and prevented?

Mann: No, and it can't be spotted in U.S. companies either. You don't have to go back a long way to find some unbelievable frauds in the United States. And some of which, I would point to, are happening now. You know, publicly traded companies where the insiders are simply just draining the company of money; you see it a lot in the oil patch. It's really, really hard to do, because no company ever has said, "Hey, by the way, you might want to take a look at those disclosures on page 34 because there, there be dragons. Frauds are meant to fool you.

I mean, you're talking about the process that they used was really all-encompassing, so I think the question for us may be twofold, the first of which is, why didn't we react to it? And the second is, why would you invest in an environment in which this is possible?

So, the first, why didn't we react to it is, short reports come out on companies all the time. And I say this without being pejorative in any way, but every single company, publicly traded or private, has some material weakness in its accounting. The language of accounting is in fact one that does not allow for precision. So, like, for example, in the United States. The least often-occurring last number in an earnings report is the number nine, because companies have all figured out how to go to the cookie jar to get themselves up to that next integer, to the next, you know, so instead of $0.89 it's $0.90; instead of $0.99, it's a $1. That shouldn't happen, I mean, that is, it should be a normally distributed thing.

So, for a company like Luckin, you have to know ultimately that every company has something going wrong with it. We didn't react to this because we don't tend to react to short reports because there was another company that was very similar to this, probably six years ago, seven years ago, the same short-seller put out a report on a company called New Oriental Education, the ticker is EDU, it's a Chinese education company trades here in the United States, saying essentially the same thing. And it turned out that even if they were right about the actual deficits in their accounting, it didn't turn out to be meaningful. And that company was trading at $12 then and it's been over $150 now.

So, yes, there are things that are out there, we are very mindful of the fact that in many more situations, the deficits aren't meaningful.

Flippen: I love the fact that you brought up New Oriental Education because I was also going to bring up EDU if you didn't. I think that is a great example of the fact that you don't want to be throwing out the baby with the bathwater, especially when you're choosing to invest in companies like those in China. I lived in China for four years, I've been a big proponent of investing in China. And I think one of things that you and I and a lot of investors acknowledge is that you are never going to be able to A. remove the Chinese government from Chinese investments, but B. remove the risk of fraud from any of the companies that you invest in.

And if you choose to sit out on all the opportunities that are out there out of fear of buying into a company that could have defrauded investors the same way that Luckin Coffee, kind of, committed fraud, then I think you miss out on great opportunities.

Mann: Definitely parts of their management team did. And I think Luckin is at least guilty of incredible material weaknesses in their processes to not notice that 60% of the revenues didn't exist.

Flippen: Well, I don't want to harp on Luckin too much, because Luckin, it's very topical, it's the most recent example that we have. But the issue of financial fraud obviously existed before Luckin, it will continue to exist after Luckin. But when you think about financial fraud, when choosing to invest in any company, what are red flags that you tend to look for?

Mann: So, one of the easiest red flags that I find is actually going through and reading -- the first thing I read whenever I look at an annual report is there is something that's an auditor's opinion letter. And sometimes, usually it'll say, we've looked at everything they gave us, it looks clean in all respects. If there is any mention of a material weakness at a company, I am done. Because auditors, like us, can only audit the information that is given to them. So, if they're finding material weaknesses, you just have to grab hold of the cockroach theory and figure that they are, that there's a lot more. So, that's one.

There are other things that you can do, and it's hard in an environment in which interest rates are near zero, but there are certain hints. So, if a company has a massive cash balance and they managed to get almost no interest from that cash, you have to ask yourself is that cash real? Does it really actually exist? Because every company doesn't -- you know, they don't sit on cash in a passbook account, they use that cash and lend it out into the repo market, things like that. So, there are certain things that you look for that don't quite match up.

And the other thing that I do is, with companies, I'll read the annual letter from the CEO, from the chairman, the chairperson, whoever it happens to be, and on a year-by-year basis, if they are pointing to different things that were great, I just assume that they are not telling us things that have ceased to be great.

So, like anyone else, we are not necessarily equipped to find frauds, what we ought to think about for ourselves is focusing on companies that are focused on the same things that we want to own. Finding frauds is really, really hard.

Flippen: Yeah. And that makes a lot of sense. I know personally, I invest in a lot of companies that report under IFRS, in which an auditor is not obligated to attest to the effectiveness of the internal controls, so we lack a lot of insight into those types of companies. And also, high growth companies. So, for certain periods, even high growth companies that are listed on major U.S. exchanges, reporting under U.S. GAAP are free from a lot of the -- they're called emerging growth companies, but they're free from a lot of the requirements of attesting to effectiveness of internal controls. And this has really allowed for a lot of companies to develop material weaknesses under the guise of -- guise is a strong word -- but with intent of saving money on regulatory burdens.

Mann: Yeah. I mean, if you are worried about Chinese fraud, you should spend a little time and google the word "LongFin financial in the United States." It was trading on the Nasdaq and it was a full-stop fraud that came public in the United States through the Jobs Act through the emerging small growth companies' provisions. And, yeah, it can happen anywhere.

There is one other way, Emily, I wanted to tell you, when you're looking for frauds, is to recognize that every company in a sector is in fact beholden to the same economics as everyone else. Not to harp again on Luckin too much, but the thing that I really feel like I should have noticed was that their margins were so much higher and so different from other companies in their sector. Now, that could be a sign that company X is a better operating company, but it could also be a sign that things are not as they seem.

Flippen: Yeah, it's a great example. And I am afraid that I've highlighted a lot of concerns we have. And again, just because the risk for fraud isn't there, doesn't mean that I think investors shouldn't invest in any company that reports under IFRS, shouldn't invest in any company that isn't international company or shouldn't invest in any company that is under the Jobs Act, reporting as a high growth emerging company, but it is to say that, I think, when we look at these companies, they do require a special level of care and diligence in addition to what you said about comparing them against their peers and looking for red flags that way.

One of the things I always look for is the difference between accounting net income and operating cash flow. Now, there are some very real reasons why a company may not be making as much operating cash flow as they will net income, because there are accounting differences. But if for years companies are reporting "profits" but not generating any cash flows, that could not only be a sign of just a bad [laughs] business model, right; if it is true, a bad business model. But also, the fact that their cash flow statement tends to be a little bit harder to manipulate, cash isn't actually existing for these companies.

Mann: Yeah, totally right. And again, finding fraud is really, really hard, but one of the things that you want to do to harden yourself as an investor is -- I think, of it as being a skeptical optimist. I mean, think about what the short-sellers are doing, they're like, "Everything is wrong," you know, they are skeptical pessimists.

Being an investor and owning the companies that are going to turn out to be the Amazons of this world means that you're going to put yourself at risk of owning companies that are not what they say they are, in small ways or in big ways. But, yes, I mean, looking at -- you know, hardening yourself and figuring out some of those places where you can look, not so much to say like, OK, this company needs to be thrown off the exchanges and arrested and everything else; your biggest goal as an investor is to not be exposed to many of those over your investing career, right? You're going to get hit at some point; you are. And you might not even know it, unfortunately. Sometimes you will know, but it is simply the case that what we want to do as investors is not necessarily find the frauds, it's to stay away from the situations where companies might be frauds or they might not be what they say they are.

Flippen: We talked a little bit about short reports earlier, and I kind of want to touch on it again. I work, obviously, in the cannabis space, I've talked about this previously, but there's been short reports in the cannabis space that have been hilariously lacking substance. In fact, over the past few years, we've seen a number of, I'm going to say "research firms" in quotes, because that's how skeptical I am of their businesses, but a lot of "research firms" coming out and making really bold, false claims against companies saying there are short reports, right? Putting in a short position on these companies, trying to push the share price down.

But then we also have Muddy Waters, which did a lot of research into Luckin and a lot of people made the same claim against Muddy Waters that I just made against a lot of these short companies, but that ended up being true.

So, when you look at a company in your portfolio that you really like, let's say, it's a, you know, not necessarily an Amazon, that's a time-tested, proven model, but let's go back to last month's example of Bakkafrost, it's a company you like, you understand their business, you see really strong competitive advantages, but a short report comes out against them. How much --

Mann: [laughs] ... they're actually selling trout, you know, the salmon don't exist. Yeah, I mean, it's exactly right. And I will say, and this is a perhaps controversial opinion, I admire, as a whole, the people who put out these reports. And one of the reasons why I think that it was actually a positive that the way that Luckin responded, is that they have been held accountable. If you think about what short-sellers do is they're holding companies accountable. And I actually think it's a healthier system in countries where that exists. In all countries short-selling is illegal, and you know, I put a much higher incidence of fraud in companies in those markets. I take this stuff very seriously.

But you have to keep in mind that in so many situations, even if the short report sounds unbelievably rock-solid convincing, they may not be pointing to meaningful stuff. And you know, I don't not react to short reports, I read them and I think about them, but at some point, you have to make that determination, yes, I think this is real. And here's the thing, Emily, they're probably, generally always or mostly, right, but does it matter? Does it matter what's happening?

You know, there was a devastating short report on Shopify. Totally wrong. And not even that it was wrong, it just they were pointing toward stuff that it was not useful to worry about. And so, you've got to take these sorts of things with a grain of salt. But I do not recommend and I don't practice in my own investing, simply saying, "Oh, they're just trying to benefit from the stock being pushed down." Even though some of them are.

Flippen: I do have one last question for you, Bill, before we close up here. Let's say a company in your portfolio is committing financial fraud, it's been announced, it was clear, they acknowledged the mistake and they vow to improve it. What do you do? Do you immediately sell or is it really a case-by-case basis?

Mann: I think it's a case-by-case basis. And I have actually held companies through the frauds, what I really want to see is the people who were responsible for the fraud, and by responsible I mean one of two things, either they were the ones who did it or they were the ones who missed it, to be shown the door. Right? Like, so, if the company says, "Oh, you know, we may have committed just a little bit of fraud, but Steve says he'll never do it again." No, like, no, no, no, no. Right?

So, I want to see accountability on a very personal level, because -- and this is really important -- because it is really hard to prosecute individuals for things that they have done at work. You know, these types of frauds, it's very easy for the CFO to say, "Oh, well, you know, the guy, one of the bean-counters blew it," And for the bean-counter to say, "Oh, the CFO told me to do it," And so you can't get a case on them, they need to be held responsible by being fired, let go, fined, you know, whatever it takes. Otherwise, I'm done.

And if the fraud seems to be something that I no longer have any real idea what the company's financials look like or what the business looks like, I'll sell.

Flippen: I love that perspective and now I feel the need that I should go and sell off all of my Chinese holdings. [laughs] I'm joking, I'm joking, of course.

Mann: No, but it's interesting. So, like, right after Luckin Coffee, [TAL] had something that came up, and it was like, 3% of its business, something that was so small that it had never been even mentioned in one of their presentations. And they said, the person who has done this has been fired and is being prosecuted. Like, OK; right. I take that you are taking this seriously at a level that you almost don't have to. And to me, that's meaningful.

Flippen: Well, Bill, thank you again for joining me today. I love doing these with you, it's always so easy. It requires very little prep on my part because you're so knowledgeable in the space, but more importantly, I think it gives our listeners a great perspective for how they should think about a lot of their more volatile investments during these times.

Mann: Emily, I love spending this time with you. I miss you at the office and I'd love to do it whenever you'll have me come back.

Flippen: [laughs] Well, hopefully we'll all end up, everybody listening and everybody at The Motley Fool will end up healthy and back in our offices at some point in the near future.

But for now, listeners, that does it for this episode of Industry Focus. And if you guys have any questions or just want to say, "Hey!" you can always shoot us an email at [email protected] or tweet us @MFIndustryFocus.

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear.

Thanks to Austin Morgan for his work behind the screen today. For Bill Mann, I'm Emily Flippen, thanks for listening and Fool on!