Avoiding Another Theranos: Key Red Flags for Potential Investments

By now, the investing world is familiar with the collapse of the company Theranos and its continuing fallout. In this video clip from "The 5," recorded on Sept. 24, Fool.com contributors Brian Withers, Demitri Kalogeropoulos, and Jason Hall discuss the lessons that the Theranos situation can teach investors about evaluating risky companies. 

Brian Withers: I wanted to talk a little bit about the Elizabeth Holmes situation. The trial is finally getting underway. You might have heard of a company that she founded called Theranos. You might remember that she was on the cover of Fortune, in 2014. I didn't realize that she founded the company in 2003 when she was 19, [laughs] I didn't realize that part, she was quite young. At peak, right around 2014-2015, the company was valued at $10 billion based on some of the investments that they've made. But in 2015 and 2016, the Wall Street Journal started reporting on issues at the company and things started to unravel, and the company finally collapsed in 2018.

If you're not familiar with the story, there's a really neat movie on HBO called, I think The Inventor, they did a really nice job. They interfaced real clips of the company and things happening there with discussions with the Wall Street Journal reporters, and the folks that broke the story, and some of the folks on the insiders, absolutely fascinating. But this is a story of things that went terribly wrong for investors. Back to the debt thing, we're looking at how mistakes get made and we're trying not to have repeat issues. Are there criteria that you consider beyond the must-not-have [laughs] when looking at companies to invest in? Whether it's history of losses, SEC investigations, whatnot.

Demitri Kalogeropoulos: If I'm first interested in a company, doing a broad look at it, if I see the phrase "material weakness", automatic red flag goes up. There's two things. The material weakness was some long time in the past and the company has course-corrected, improved their controls, and that's a good thing. That might be a good thing because it led the company to tighten up their financial process. But if it's something more recent, then that's a red flag. There are so many high-quality companies, like what we just talked about, just in the Fool universe, there's hundreds of good stocks out there. You don't need to be investing in companies that have questionable accounting practices that have an SEC regulatory overhead that you have to deal with, and that are in the news all the time, that kind of thing. Material weakness is something to stay away from, specially for beginner investors who aren't really digging into the true meaning of what that is.

Another thing that a lot of people might not think of that I pay attention to is, so I like companies whose CEOs or founders write shareholder letters. That's just to get a sense of how the CEO talks, what he focuses on, how he communicates with investors. If you hear a CEO in their letter or in their quarterly conference calls talk about the stock price, that to me is a red flag. A perfect example is the whole GE fiasco 15 years ago, where I think the company was manipulating sales numbers, and then Jack Welch was [inaudible 04:40:47] and they brought a new CEO in. The whole thing went [inaudible 04:40:51] when both of those CEOs would talk about stock price, would talk about the PE multiple on their earnings calls. I don't want my CEO of the company I'm investing in focus on that. I want them focused on the day to day operations, how are they going to steer the company over the next five years. Then again, just another point I'd like to add is, I don't necessarily turn away from a company who's had a history of losses, especially in today's economy where you have a lot of these fast-growing high-tech businesses who are constantly investing in the business. A history of losses wouldn't necessarily turn me away, but I think the main thing is that material weakness in the company's accounting controls.

Withers: Demitri, what's your perspective on this?

Kalogeropoulos: I agree with that too. I was just echo a lot of that. I would definitely say you mentioned SEC investigation. I think that's one of those cases where it makes sense, I guess we like to rag on Wall Street for being too short-term focused and over-reacting to things. But I think the announcement of an SEC investigation into your accounting practices is one of those situations where it makes sense to overreact. I totally understand it. There's that saying in the justice system where you're innocent until proven guilty, but that's not the way it works with an SEC investigation. At least on Wall Street, when there's an announcement that regulators suspect you of cooking the books, it's not uncommon to see a stock drop. That seem stock dropped 50, 60, 80 percent in that day. I understand why because we're calling in to question your financial statements, the way you've been presenting yourself to us.

If we investors can't trust the numbers that you gave us to evaluate you on, then we don't really have a basis to invest. The other thing is, call this another saying, but if you've heard of, if you found one cockroach, it's probably not the only one. [laughs] I think it makes sense. It's not a place where I would give a management team a whole lot of leeway here. If there's one instance of regulatory misstatement like that, there will probably will be more and I'm not going to be sitting around to wait for the other shoe to drop. I'm also not going to be interested in your stock. You might be attracted to a company whose share is 50 percent cheaper today than it was yesterday just because of this one investigation. But I don't even know playing that game. There's a lot of other higher-quality places you can invest.

Jason Hall: I'm going to read this as you put on the outline, Demitri, "If I can't trust your financials, we have no basis to do business together." That's says it so well. For me, this is really what it boils down to with most penny-stocks. I think something a lot of people don't realize is, especially the uninitiated investor thinks that, and they may read an article that says, Apple's shares traded for split adjusted 10 cents a share when it went public, and they don't understand it was never 10 cents a share. It was $35 a share, but various split since then. They think they have to buy stocks that are literally trading for pennies to make money without understanding that so many of those companies, because of their size, actually fall below SEC thresholds when they have to submit audited financial statements.

Penny-stocks, because of this, they're rife for fraud because they're essentially built as the perfect thing to put fraudulent information or to be incredibly creative with things because you don't have to run it through one of the big auditing firms, one of the big accountancy firms and then the auditor signs off on it, and then you submit it to the SEC. Substantially lowers the threshold for what shows up in these filings and creates enormous risk. What they're telling you is not necessarily accurate and some cases, it's absolutely not true. I think that's a really important thing to understand about penny stocks and why I won't do business with penny-stocks, and God, we trust all others pay cash.