There's little question that small caps offer some of the best returns in the market. Unfortunately, they're also the most susceptible to fraudulent accounting practices.
High-profile accounting scandals at large firms such as AIG (NYSE:AIG) and Tyco International (NYSE:TYC) are easy to recall because the scandal affected a large number of shareholders and naturally received a great amount of media coverage. But for every large-firm scandal we hear about, there are multiple small-firm scandals we never hear about.
Small-company secrets
In a separate statement of a 2006 SEC report on small companies, Kurt Schacht, a CFA and executive director of the CFA Center for Financial Market Integrity, noted that small companies "consistently have more misstatements and restatements of financial information, nearly twice the rate of large firms. Alarmingly, these small firms also make up the bulk of accounting fraud cases under review by regulators and the courts (one study puts it at 75% of the cases from 1998 to 2003)."
The main reason for this, Schacht argues, is a lack of strong internal controls in most small companies. While large companies tend to have massive internal audit processes to catch discrepancies before the market does, small companies either don't have the capability or don't find it necessary to devote a large amount of capital to such a process.
Someone else might be to blame for the lack of internal controls -- investors.
What, me worry?
According to Schacht, the SEC report suggests that "investors in these companies don't particularly care about internal control protections and that these companies represent an inconsequential bottom 6% of total U.S. market capitalization, rendering even and Enron-like blowup a minor event."
In other words, investors aren't holding small companies to the same accounting standards that they do large companies. Perhaps the reason is that small-cap investors would rather see as much money as possible spent on programs to fuel the company's growth, like R&D. This is all well and good, but what do the growth numbers mean if they're not accurate?
Cheaters never win ... at least in the long run
We've all seen what happened to the stock prices of small-cap upstarts KrispyKreme (NYSE:KKD), Rite Aid (NYSE:RAD), and MicroStrategy (NASDAQ:MSTR) after alleged accounting scandals surfaced. It's not a surprise that all three cases of fraud took place during periods of intense competition and growth. Rite Aid's number-fudging, for instance, took place in the 1990s in the midst of a period of rapid expansion and bitter battles with rivals CVS (NYSE:CVS) and Walgreen (NYSE:WAG).
But the question remains: Why would a company take this kind of risk?
Howard Schilit, in his 2002 book Financial Shenanigans, offers three very compelling and basic reasons:
- It pays to do it.
- It's easy to do.
- It's unlikely you'll get caught.
The first makes enough sense. If your company has a string of astronomical earnings surprises, the stock price will inevitably skyrocket. Indeed, Krispy Kreme was a four-bagger in three years before it all came crashing down in 2004.
The government can't protect you
The Sarbanes-Oxley Act of 2002 has made it more difficult for companies to get away with accounting shenanigans, but there are still a lot of undefined terms left open to interpretation. Earnings figures in particular remain one of the easiest to distort through the use of aggressive revenue recognition, varying inventory calculations, and depreciation methods.
You probably know a guy who honestly believes that the IRS will never catch on to his intentionally underreported income or his bogus deductions every year. The same logic happens in corporate boardrooms. What's more, quarterly reports, or 10-Qs, do not have to be audited by an independent third party, which gives companies at least a full year to cook the books before an independent auditor would catch on.
Moreover, because small caps typically aren't followed by a throng of Wall Street analysts, fewer tough questions are asked of management during conference calls, leaving more time and opportunity for shenanigans to take place.
Foolish bottom line
So what's an investor to do? A lot, actually. For starters, look for small caps with conservative accounting practices, positive free cash flow, responsible management, and a history of underestimating and overdelivering on promises to shareholders.
That's how Motley Fool co-founder Tom Gardner and his team find companies to recommend for their Motley Fool Hidden Gems service. And their due diligence is paying off. Hidden Gems recommendations are up 30% on average since 2003 -- a full 16 percentage points ahead of the S&P 500.
Numbers are meaningless if they're not accurate. So if you'd like some help finding the market's best small caps, consider a full-access free trial of Hidden Gems. Just click here for more information.
Todd Wenning enjoys shenanigans of a non-accounting variety now and again. He does not own any shares of companies mentioned in this article. Tyco is an Inside Value choice. The Fool is investors writing for investors.
