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Investing Red Flags


BG2008

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Years ago, I did a little presentation on management red flags and it was a lively debate and I walked away smarter than I was going in.  So I will this topic up again and list some observations.

 

1. If an investment manager is being compared to Buffet, be very skeptical

2. If an annual letter quotes Buffet, be very skeptical

3. If a company uses a lot of value investing lingos, be very skeptical

4. If you are doing a DD on a CEO and no one has anything bad to say, be very skeptical.  It's because being CEO involves tough decisions.  You will have to disappoint and/or piss off some people to make the right judgement calls. 

5. Buying back shares to offset dilution, buying back stock for any reason other than it creates a lot of value is a red flag

6. Companies with high ROIC and growth figures that are highly prized by the investing community spinning off a lesser quality company and saddling it with debt and/or environmental liabilities, be careful.  Companies have figured out that there are value investors willing to take the other side of the trade and dumping toxic waste into the spinoffs. 

7. Contrarian - The market is right more often than not. 

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A couple of management\CEO red flags that I took away from the book "The Smartest Guys in the Room":

 

1. Obsession with the stock price

2. Obsession with short sellers; creating a narrative of us vs them, and short sellers are evil

3. Inexperienced\young CFO for a multi-billion dollar corporation (there isn't anyone more qualified who wants the job?).  I hate to age discriminate, because I am relatively young myself.

4. Weak board of directors beholden to the CEO.

 

There are probably more, but this is just off the top of my head.  Sound like anybody else you know?

 

I also tend to avoid stocks with high short interest.  Like you said, the market is normally right.  I know I'm not smarter than most of the short sellers out there.

 

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A couple of management\CEO red flags that I took away from the book "The Smartest Guys in the Room":

 

1. Obsession with the stock price

2. Obsession with short sellers; creating a narrative of us vs them, and short sellers are evil

3. Inexperienced\young CFO for a multi-billion dollar corporation (there isn't anyone more qualified who wants the job?).  I hate to age discriminate, because I am relatively young myself.

4. Weak board of directors beholden to the CEO.

 

There are probably more, but this is just off the top of my head.  Sound like anybody else you know?

 

I also tend to avoid stocks with high short interest.  Like you said, the market is normally right.  I know I'm not smarter than most of the short sellers out there.

 

I know you're not talking about Tesla!

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If investment manager misspells Buffett as Buffet, be very skeptical.  ::)

 

Jurgis,

 

That's micro-aggression and discriminatory towards those of us ESL speakers.  #quit_your_privilege :)

 

Sorry, it's just my OCD & spectrum showing up.  ::)

Sorry, it's just my OCD & spectrum showing up.  ::)

Sorry, it's just my OCD & spectrum showing up.  ::)

 

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If investment manager misspells Buffett as Buffet, be very skeptical.  ::)

 

Jurgis,

 

That's micro-aggression and discriminatory towards those of us ESL speakers.  #quit_your_privilege :)

 

Sorry, it's just my OCD & spectrum showing up.  ::)

Sorry, it's just my OCD & spectrum showing up.  ::)

Sorry, it's just my OCD & spectrum showing up.  ::)

 

LOL

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I would say as a general comment if you see multiple red flags write them down and see what they add up to.

Usually a picture can be created of a CEO's /mgmt's mentality taking multiple data points and not ignoring them.

 

Here are some I have noticed over the years:

 

1.  Read the entire annual report.  One reason Buffett reads the Annual report/10-k is that it leaves a trail of what type of CEO

is running the business.   

2.  Is the CEO letter if full of spin and BS? 

3.  If they start making up all their own accounting metrics and don't mention Net income.  I think GE was making up their own adjusted pension numbers, etc. WTF.

4.  Is the 10-K clear and simple to read?  The truth is simple.  Frauds often make 10-K's long and complex to confuse, tire you out and have most people give up.    The bad stuff is lost in the details.  Business should be simple at the end of the day.

5.  Are they screwing around with earnings manipulation to smooth earnings over?  You need to be skilled here.

6.  Lots of deals can hide a lot things.  Adds a lot to complexity and hard to figure out what is going on.  Tyco, GE, Valeant, all the failed rollups. 

7.  A CEO that is aggressive with short sellers is a major, major red flag.  There is an enormous historical precedent for this.  The more aggressive- the more likely it is a fraud.  If you are CEO of a legitimate business and some finance guy hates the stock - if you and your business are real you can just keep selling to customers, grow and he will likely lose in the long run.  But - if the short seller is criticizing a fraud heavily and the fraud has nothing really behind it then it is going to hit a nerve as the FRAUD IS HIS LIFE and go after them.   

 

 

And btw - if you actually read the 10-K you will be ahead of a huge percentage of speculators who don't do this.  Even many value investors who manage over $1 billion don't read them.  And much of the time the frauds are obviously bad - you never know how bad - but  you could of seen how the books were being cooked even years ahead of time while the stock kept on plowing higher - until it collapsed.

 

And the Auditors wont catch shit. They seem useless in this regard and sold out long ago. 

Por la plata el mono baila.

 

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I would say as a general comment if you see multiple red flags write them down and see what they add up to.

Usually a picture can be created of a CEO's /mgmt's mentality taking multiple data points and not ignoring them.

 

Here are some I have noticed over the years:

 

1.  Read the entire annual report.  One reason Buffett reads the Annual report/10-k is that it leaves a trail of what type of CEO

is running the business.   

2.  Is the CEO letter if full of spin and BS? 

3.  If they start making up all their own accounting metrics and don't mention Net income.  I think GE was making up their own adjusted pension numbers, etc. WTF.

4.  Is the 10-K clear and simple to read?  The truth is simple.  Frauds often make 10-K's long and complex to confuse, tire you out and have most people give up.    The bad stuff is lost in the details.  Business should be simple at the end of the day.

5.  Are they screwing around with earnings manipulation to smooth earnings over?  You need to be skilled here.

6.  Lots of deals can hide a lot things.  Adds a lot to complexity and hard to figure out what is going on.  Tyco, GE, Valeant, all the failed rollups. 

7.  A CEO that is aggressive with short sellers is a major, major red flag.  There is an enormous historical precedent for this.  The more aggressive- the more likely it is a fraud.  If you are CEO of a legitimate business and some finance guy hates the stock - if you and your business are real you can just keep selling to customers, grow and he will likely lose in the long run.  But - if the short seller is criticizing a fraud heavily and the fraud has nothing really behind it then it is going to hit a nerve as the FRAUD IS HIS LIFE and go after them.   

 

 

And btw - if you actually read the 10-K you will be ahead of a huge percentage of speculators who don't do this.  Even many value investors who manage over $1 billion don't read them.  And much of the time the frauds are obviously bad - you never know how bad - but  you could of seen how the books were being cooked even years ahead of time while the stock kept on plowing higher - until it collapsed.

 

And the Auditors wont catch shit. They seem useless in this regard and sold out long ago. 

Por la plata el mono baila.

 

Con la banana en la mano...

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The biggest sign I've seen of late, which hit me hard in the past (CB&I), was when there's a conference call about new "bad" information, that is "brushed off" and disclosure in the 10Q is much worse than it was made to be. Sell immediately lol. Further, if that doesn't confirm it, when the CEO sells the vast majority of his shares a few months later - don't be stuck holding the bag. It's not a good feeling knowing your intuition was right but you thought it would be a one-over.

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Off of the last post, something Ive seen before.....when "new" risk factors are disclosed in the new 10k that hasn't been previously addressed. When items are disclosed in 10q but not on calls or at conferences, and also watch out for "subsequent events" disclosures. Lot of ways guys can bury bad news. Also, if you are familiar with a company, watch for when language changes. If something has "been" a certain way for a while, and then all of a sudden the same things are said differently, there is usually a reason.

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I would say as a general comment if you see multiple red flags write them down and see what they add up to.

Usually a picture can be created of a CEO's /mgmt's mentality taking multiple data points and not ignoring them.

 

Here are some I have noticed over the years:

 

1.  Read the entire annual report.  One reason Buffett reads the Annual report/10-k is that it leaves a trail of what type of CEO

is running the business.   

2.  Is the CEO letter if full of spin and BS? 

3.  If they start making up all their own accounting metrics and don't mention Net income.  I think GE was making up their own adjusted pension numbers, etc. WTF.

4.  Is the 10-K clear and simple to read?  The truth is simple.  Frauds often make 10-K's long and complex to confuse, tire you out and have most people give up.    The bad stuff is lost in the details.  Business should be simple at the end of the day.

5.  Are they screwing around with earnings manipulation to smooth earnings over?  You need to be skilled here.

6.  Lots of deals can hide a lot things.  Adds a lot to complexity and hard to figure out what is going on.  Tyco, GE, Valeant, all the failed rollups. 

7.  A CEO that is aggressive with short sellers is a major, major red flag.  There is an enormous historical precedent for this.  The more aggressive- the more likely it is a fraud.  If you are CEO of a legitimate business and some finance guy hates the stock - if you and your business are real you can just keep selling to customers, grow and he will likely lose in the long run.  But - if the short seller is criticizing a fraud heavily and the fraud has nothing really behind it then it is going to hit a nerve as the FRAUD IS HIS LIFE and go after them.   

 

 

And btw - if you actually read the 10-K you will be ahead of a huge percentage of speculators who don't do this.  Even many value investors who manage over $1 billion don't read them.  And much of the time the frauds are obviously bad - you never know how bad - but  you could of seen how the books were being cooked even years ahead of time while the stock kept on plowing higher - until it collapsed.

 

And the Auditors wont catch shit. They seem useless in this regard and sold out long ago. 

Por la plata el mono baila.

 

Awesome Post

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Off of the last post, something Ive seen before.....when "new" risk factors are disclosed in the new 10k that hasn't been previously addressed. When items are disclosed in 10q but not on calls or at conferences, and also watch out for "subsequent events" disclosures. Lot of ways guys can bury bad news. Also, if you are familiar with a company, watch for when language changes. If something has "been" a certain way for a while, and then all of a sudden the same things are said differently, there is usually a reason.

 

Any examples of the sudden changes in when languages changes and subsequent events? 

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Just want to present a Case Study on Garret Motion which has been a cluster f of an investment

 

Look at this spinoff presentation from 2018, it just seems like a page from Joel Greenblatt's spinoff play

https://s2.q4cdn.com/726657224/files/doc_events/2018/09/1/Presentation.pdf

 

They just announced that they may need restructuring.  Honeywell spunoff a potentially legacy/dying business and used all the value investor buzzwords and got an IR guy who was good at talking to value guys.  This seemed very trivia at the time because the thesis and fundamental seemed very solid.  Someone mentioned that Paul Blalock was very "loosey goosey" with the facts and it made me pause.  My friend also told me that once the market deems something terminal, you will never get a good multiple on it.  I am so glad I paid attention to those comments because I was very close to pulling the trigger. 

 

Some quotes from a message forum 

"Or maybe holders are growing more distrustful of Paul Blalock alla widowmaker. I kid I kid..." 

 

"I met with the IR guy at a NYC conference yesterday and I am starting to see that all the pro-arguments in this thread is something that the IR guy has mentioned.  These are purely behavioral observations. 

 

It seems like Paul's got a pitch down pretty well.  His words were just rolling off.  There were no hestitancy.  He's clearly been practicing the pitch about the Bosch-Mahle JV and why that failed to gain traction.  He had a great explanation on why cars going to be electrified but not pure EVs.  I suspect that the 10 to 1 boost in hybrids is a concept/pitch that he came up.  It just feels like all the information that is being presented in the write up and in the thread has his finger prints all over them.  All the pertanent info of why GTX is a good business and why the future is really hybridization and not pure EV.  The explanation of why variable geometry is such an advantage for GTX.

 

When asked about Borg, he basically said that Borg just wants to do projects that generates a return above their cost of capital.  GTX and its Honeywell DNA are very discplined about capital allocation and will only move forward if returns on projects are ridiculously high. 

 

Honeywell pretty much bought the IR guy inhouse in preparation for the spin.  When asked why did they put the debt on GTX, he said "because they can" The IR guy mentioned he went to Honeywell and asked them why Honeywell will retain the tax benefits, the HW response is "because we can, now get out of here."  HW asked the IR guy how much of the cashflow from GTX can Honewell take and still build a shareholder base.  The IR guy said "half".  That's pretty much why the asbestos is capped at $175mm.  Now, the IR did push back on a few things and pretty much turned the asbestos liability into a preferred stock where if paying the $175mm were to trigger a defaul, GTX can PIK the asbestos payments at 5% a year.  That's a nice feature and the asbestos liability should be thought of as preferred stock rather than debt. "

 

"I am on the sidelines and have not spoken to the company.  Just something for people to think about, to the extent the GTX IR person is helping some here form opinions on the stock, I offer a personal anecdote:

 

Once upon a time I owned WLT.  And a friend of mine said, “We owned CLWR.  The IR guy at WLT came from CLWR.  We’d probably own WLT too because it looks cheap, but I don’t trust him.”  WLT eventually filed.  I lost money and he lost none.  Later in life I spoke to this IR person numerous times while at CSTM.  I (and apparently, as I later learned, at least one person that worked with him) found him to be pretty loosey-goosey with facts, but always to the upside.  That friend’s comment kept me away from CSTM during his tenure, which ended up being a good call." 

 

This is perhaps a lesson on how to set traps for "value investors" 2020 version. 

 

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Off of the last post, something Ive seen before.....when "new" risk factors are disclosed in the new 10k that hasn't been previously addressed. When items are disclosed in 10q but not on calls or at conferences, and also watch out for "subsequent events" disclosures. Lot of ways guys can bury bad news. Also, if you are familiar with a company, watch for when language changes. If something has "been" a certain way for a while, and then all of a sudden the same things are said differently, there is usually a reason.

 

Any examples of the sudden changes in when languages changes and subsequent events?

 

Will try to go back and find a few. The couple I can think of, for several reasons, I probably dont want to disclose(ever gotten a cease a desist from a company? lol). Its partially a byproduct of following stuff a little too OCD and getting up peoples asses when they arent doing their jobs. But generally speaking, especially around proxy season, the releases are run by counsel. So the subtle changes, typically arent by accident. When boilerplate language gets changed, there is almost always a reason.

 

Paraphrasing one from a bit ago, a specific company press release used to almost always tout its belief in their discount to FV. Then the releases stopped containing that couple sentences. Next quarter they did a dilutive transaction.

 

Another one I can think of is when company's management harps on a story or narrative, and then the story/narrative runs its course, and they just change the story/narrative without ever addressing the previous one. This is a constant theme I look for in shorts....Cough Dropko Health.

 

On the subsequent events section....I've found that often it is(the 10Q) released to comply with announcement of material events, if indeed they are deliberately burying stuff. Which brings me to another one....announcing bad news on a Friday after the close or on the half day of trading before big holidays.

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And the Auditors wont catch shit. They seem useless in this regard and sold out long ago. 

Por la plata el mono baila.

 

If you run a fraud, you definitely want auditors that work shit. Or does it make sense for managers to pay auditors to uncover your fraud?

 

There are actually, a couple well known, "go-to" auditors that always seem to be associated with....certain types of companies. Just like there are a couple well know law firms that seem to always get a lot of business from the P&D's or serial equity issuers.

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