A bag o' syringes and a bashed-up barricade
One of the strangest stories out of this year's Winter Olympics has to be the doping scandal involving the Austrian ski team. According to various news reports I read, an Austrian coach serving a long-term ban for previous doping violations (at the Salt Lake City Olympics) was seen in the area of the Turin games and appeared to spend a night with members of the Austrian Nordic ski team. When police raided those athletes' rooms, bags of syringes and other suspicious stuff were tossed out windows and afterward confiscated. That fallen Austrian coach was later apprehended after he rammed a police barricade with his car, and his frazzled mug shot was distributed worldwide. The first tests run on the evidence have come up negative, but that won't be enough to clear the cloud over the Austrian team, and the investigation continues.
Just as it will be tough for the Austrians to move past this rough spot, so the whiff of scandal at businesses can create clouds that take a long time to clear. The problem with investing is that your potential for loss doesn't require corporate deeds that rise to the level of illegal. Unethical, overly optimistic, or simply curious behavior is more than enough to sink you.
You can't avoid these situations 100% of the time, but you can learn to recognize two of the most common ways businesses dope their numbers. By staying vigilant, you can avoid firms with a propensity to cheat and thereby improve your odds of winning the long race that is investing.
The short cut
Shortcuts to earnings and growth account for one of the most common forms of cheating. It's also the most basic. This is accomplished most often via aggressive revenue bookings -- such as "stuffing the channel" -- or blatant cheating on expenses. This happens all the time. On Jan. 4, the Securities and Exchange Commission announced charges (and a $50 million fine) against McAfee
On Feb. 22, the SEC announced a settlement with four auditors at KPMG relating to a "$1.2 billion fraudulent earnings manipulation scheme" by Xerox
Creative accounting for promotions and other credits is yet another way companies can get in trouble. Last fall, GM
The blood bank
When most people think of doping, they think of athletes using various kinds of banned chemicals to boost their performance -- erythropoietin (EPO) or steroids, for example. But in fact, "blood doping" originally refers to the simpler process of doctoring an athlete's blood to give it a higher oxygen-carrying capacity. A very common way is via transfusion of red-cell-rich blood, either from an outside donor (homologous), or from blood harvested from the athlete himself before the competition (autologous). Both of these have analogs in the investing world, and both can cause serious problems for investors.
The outside transfusion
Enron's off-balance-sheet entities, designed to make loans, asset sales, and other transactions look like earnings, are an example of one of the most blatant forms of homologous doping on Wall Street.
The scandal at AIG
The inside job
Companies very often partake in autologous blood doping as well, setting aside earnings power when times are good only to inject it back into the income stream when they need it most. In other words, they plop earnings into some kind of reserve account and then reverse it later. They do this to "smooth" earnings and thereby placate Wall Street. Of course, the real goal of the maneuver is often for management to cheat its way to maximum personal gain.
The best example of this type of Street doping comes from the still-unfolding drama at loan giant Fannie Mae
This is only the most blatant of the piggy-bank schemes I've seen. Keep in mind that in many of these cases -- possibly, in fact, Fannie Mae's -- what was done was not illegal. And ethics, of course, vary depending on which side of the million-dollar bonus you stand.
Companies work the possibilities of the blood bank all the time. It's been more than a year now since I pointed out that Ford's
While this was no doubt legal, ethical, and even reasonable from an accounting point of view, it suggested something very important to me. At a time when other analysts were saying Ford had turned the corner to profitability, I saw a company that was desperate to find earnings and would not be finding them in the future. And unfortunately for shareholders, I turned out to be right.
Foolish bottom line
You can't catch all of the cheating all of the time, but you can learn to spot where risks are likely to hide. Any time companies are boasting unbelievable growth, it serves you well to disbelieve. When companies have giant blood banks on their balance sheets, make sure the earnings they report aren't owed to withdrawals. In investing, as in athletic competition, the most rewarding wins are those that come in a clean race, and if you take the time to read the filings, you'll be in a position to judge the competition for yourself.
If you're interested in stocks that have a clean bill of health, or, like Fannie Mae, are excessively discounted because of their scandals, we find them every month in Motley Fool Inside Value . A free guest pass is available.
Seth Jayson keeps his reading glasses handy so he can find the dopers before they find him. At the time of publication, he had no positions in any stock mentioned here. View his stock holdings and Fool profile here. Fannie Mae is an Inside Value recommendation. Fool rules are here.
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