They say it takes two to tango, and likewise, there's always two sides to every argument. With stocks, I find that there's usually a valid perspective on the other end of the trade. For every good bullish thesis, there's likely a solid bear argument. If you can't see things from another perspective, it probably means more research is needed. After all, many of the great companies of yesteryear eventually fell. And many of today's success stories overcame legitimate hurdles along the way.
However, while many counter-arguments are valid, some are just plain silly. This article is going to explore one of the silliest arguments right now against mobile-gaming platform Skillz (SKLZ 2.50%). But the point isn't to poke fun. Rather, there's an important lesson that will make all of us better investors.
Image source: Getty Images.
What does coffee have to do with gaming?
Once hailed as one of the greatest growth-stock stories of our time, Chinese coffee company Luckin Coffee was putting up incomprehensible growth numbers quarter after quarter. For example, in the third quarter of 2019, it reported revenue of $209 million, up a staggering 558% year over year. There was only one little problem: Not all sales were genuine. According to a complaint filed by the Securities and Exchange Commission (SEC), those third-quarter sales may have been inflated by 45%.
Luckin Coffee's auditor at the time was Ernst & Young. Just hold onto that little tidbit for a moment.
Skillz has nothing to do with coffee. It's a mobile-gaming platform that allows users to win money by competing against other players. The company generates revenue by taking a cut from the entry fees.
In its recent report, short seller Eagle Eye Research points out that Skillz offers bonus cash to incentivize users, which counts as an expense. However, this bonus cash is used to pay entry fees. But even when entry fees are paid with bonus cash, Skillz still takes a cut and counts it back as revenue. When you stop and think about it, that's unusual.
As it turns out, Ernst & Young is the auditor for Skillz -- the same auditor at the time of Luckin Coffee's fraud.
This firm audits both Luckin Coffee and Skillz, and that's one of the points Eagle Eye makes in its short report. The report asserts that Ernst & Young has been associated with fraudulent companies before. This appears to imply that Skillz is just the latest fraud propped up by an auditor with dubious credibility.
Image source: Getty Images.
Taking a step back
What Eagle Eye doesn't mention is that Ernst & Young is also the auditor for many other public companies, including The Coca-Cola Company, AT&T, and Lockheed Martin. Should we question the financials of these titans simply because they share the same auditor as Luckin Coffee? I think even Eagle Eye would agree that would be ... well, silly.
Furthermore, let's remember that auditors aren't investigators. After all, some employees and executives at Luckin Coffee were very clever -- not only were sales inflated, but it appears expenses were also inflated so they wouldn't get caught. Ernst & Young can't be expected to covertly traverse the entire Middle Kingdom trying to physically verify every Luckin Coffee transaction. A financial audit is based on the numbers auditors are given, and this is why the accounting firm says it's not responsible for what happened. And I believe it's reasonable to agree with Ernst & Young on this one.
Why it matters
Unfortunately, we investors don't do nuance well. We tend to overstate our opinions to the point that we become extremists in our bullish or bearish outlooks.
I have a sneaking suspicion that bears latched onto this argument about Skillz's auditor, and I also have a sneaking suspicion silly arguments like this cause Skillz bulls to throw away bearish perspectives entirely, which is also a mistake. It's throwing the proverbial baby out with the bathwater.
Eagle Eye actually does a great job of bringing the issue of bonus cash to the forefront. Looking into this, some might believe Skillz's management is being sneaky or even doing something illegal -- that goes too far, in my opinion. However, at least a portion of the company's revenue comes from bonus cash, meaning it doesn't represent the real money being deposited onto the platform. That's an issue worth discussing, and I handle the possible implications in another article.
In the end, I believe we should all be looking for opinions that disagree with our own. It's why I read the short reports on Skillz stock even though I own shares. If there's validity to their arguments, I win, because now I understand the risks better than I did before. But if their arguments don't hold water, I also win, because my conviction strengthens.
