Buyer Beware

Buyer Beware

The bottom end of the ASX is a bad place to be. There is a huge party going on at the moment and it’s happening at the expense of household investors. I wanted to write something that I hope household investors (of which I am one) will find useful. My usual disclaimer applies here, I am not a professional investor, but once you have been investing for a few years you build a list of red flags and other things that you avoid in an investment.

The trouble is that an actual expert might see 5-10 companies with warning signs, discard them without a second thought, and not feel any compunction to write about them or actually do the hard yards to prove they are terrible. This is time-consuming, difficult, risky in several ways, and you don’t get paid for it, except in rare instances where you can build your rep/FUM like Forager Funds and Dick Smith.

There is a dearth of negative stock coverage in the market, and despite the huge proliferation of advisory services, there is no market for a service that points out bad stocks. Even short sellers do not do this work because there is often no borrow on the tiny stocks, and many of these stocks get priced on hype and/or are manipulated and can conjure a higher share price seemingly from thin air, making them dangerous to short. There are no formal warnings for the household investor in small-cap speculative shares, and no market for creating any. I have done my best to pull a few things together below:

Number 1: We’re at that point in the cycle

The first thing you need to know is that it is a really good time to be selling something. At this time in the cycle, although it does not look like it among the larger companies, money is falling from the sky. Anybody who can is building something to sell to the market; SaaS, baby formula, lithium, graphite, cobalt, blockchain, crypto, Internet of Things, or even just mediocre businesses cobbled together into an IPO. I joked about a 10foot IPO not long ago, but in today’s market I actually think it’s a possibility. And if that doesn’t terrify you, it should.

Fees (say around 6% of capital raised) are paid to the broker sponsoring the IPO, so if a broker can convince enough investors to pay up, they can earn millions in fees. I don’t think there is a huge problem with brokers per se, but there are issues with the companies being sold. Anyone who can is building stuff to sell, which is a sign that you should not be buying.

Steve Johnson of Forager wrote about this phenomenon just a few days ago.

Number 2: Do not touch Chinese stocks

I would hate to beat all businesses equally with the ugly stick, but if a company’s sole business is inside China, your default position when considering an investment should be ‘this company was put on Earth to fuck me’, because I shit you not, that’s what it’s here for.

Do Chinese companies IPO because they want to sell parts of their truly great business to gweilo, or do they sell because they want real money (AUD/CAD/USD) with which they can invest in overpriced property, send their kids to foreign schools, and earn an income outside the grasp of the shade of Mao Tse-tung?  I’m sure it’s probably the first one.

In my opinion, Chinese companies sell shares because buyers hand over real cash in return for worthless pieces of paper, i.e., assets whose ultimate ownership + cash flows will never be allowed to pass outside China. Many ASX-listed Chinese companies can’t get cash out of China, so you’ll never see a cent in dividends. Investors also need to watch for off-balance-sheet liabilities, like one company guaranteeing another company’s debts, although I’m not sure how prevalent that is amongst ASX-listed Chinese companies (by definition, it’s not easy to find).

Number 3: Dodgy LIC behaviour

This has become a bit of a hot issue recently too. Probably the most important thing to understand about LICs or similar vehicles is that they are what’s called ‘captured capital’. Once the cash goes into the LIC, e.g. via a capital raising, it does not come back out. The only way to realise your stake (unless the company gets wound up, which is out of your control) is to find another investor willing to buy your shares from you.  This is hard to do at the small end of the market, and gets much more difficult if the company changes management or establishes a bad reputation. If your investment gets frozen/ suspended, the manager can continue charging management fees while your investment is locked up and you are unable to sell.

SMH wrote about Naos/Contango

AFR wrote about Aurora misplacing a million bucks

There have been comments elsewhere in the media about Keybridge Capital, Molopo, and so on.

Number 4: Misconceptions about the role of regulators

Whose job is it to figure out if a company is kosher or not?  The answer is no-one:

ASX: Market operator. Their job is to monitor compliance with the listing rules and operate the market, not to police unconscionable conduct. The ASX gets paid to have lots of companies listed and to keep its costs controlled, so it is not in its immediate interest to be delisting companies or causing them problems.

ASX compliance officers I have found are generally well aware of shady behaviour, it is just hard for them to do anything meaningful about it. You will never see an ASX officer telling a company ‘you are full of shit’ which is unfortunate because this can be the truth. Instead, investors get a query between a disincentivised questioner (the ASX) and a self interested party (the company) that is professionally polite, reasonable, an exercise in political spin, and capable of lulling an investor (or allowing them to lull themselves) into a false sense of security.

ASIC: Market regulator. But hey, if you know what ASIC actually does all day, let me know. I follow them closely and they definitely have their finger on the pulse. However they are woefully inadequate when it comes to actually regulating behaviour. Are you a dodgy financial adviser/ salesperson? Expect to have your career ruined and be banned from finance for life (justifiably so). But are you a dodgy or fraudulent company? Insider trading? Front running?  Would you mind awfully much if ASIC gives you a $50,000 fine with no admission of wrongdoing, and consults with you first to see if you thought that fine was appropriate?

The problem is that ASIC regulates compliance with the law. Their job is not (well arguably it is, but they don’t seem to do a lot of it) to forensically pull companies apart and proactively act to prevent chicanery. There are huge grey areas in finance, especially around valuation, that can be easily exploited while still appearing reasonable.

Auditor: Checks compliance with company and regulatory procedures. Many times historically, auditors have been used to add authenticity to dodgy companies. Australian audit quality is appalling, according to the outgoing head of ASIC. Additionally, it is not the auditors’ job to forensically pull apart a company. They spot check transactions, check the cash at bank, and a bunch of other things, but they don’t appear to apply professional judgement in many cases. If they do, it’s in dry, formal language in the audit report that may be unintelligible to amateur investors without the time or knowledge to understand the implications of the auditor’s concerns. Audit firms are paid by the company and can simultaneously seek to do other business with the company (conflict of interest), can have long tenures, and there are historical examples of prominent auditors getting too close to their clients and being compromised by it. It is theoretically the auditor’s job to check valuations, but there are grey areas.

So whose job is it actually to establish that a company is a fraud (or whatever the problem may be)? The investor is on their own. Professionals have the tools, skills, and experience to make the necessary judgements, but they are not paid to point out bad stocks. Some of them make money by engaging in shenanigans themselves (see LIC articles above).

Additionally, unsuitable investments are increasingly being marketed directly at retail shareholders, bypassing the rigour of institutional investment checks and unintentionally (actually, I would argue intentionally) lowering the bar for a public listing.

There are also huge disincentives up and down the market that prevent people from criticising dodgy companies.

Number 5: Disincentives for pointing out dodgy investments:

1. Career risks for analysts. You could lose your job, especially if you upset broker relationships (brokers are known to offer good deals to favoured clients). Finance is also a very small field where everybody knows and follows everybody. An analyst’s rep will stick with them.
2. Business risk. This is a broad category, including the broker relationships I mentioned above, but basically if you are a fund manager/financial adviser you could lose clients, hurt your reputation, attract negative regulatory/legal attention (especially if you’re short-selling), and so on. The risks are doubled if you’re wrong, and dodgy behaviour is rarely unambiguous, exacerbating the risk.
3. Litigation. I have not seen many Australian examples of this but it is not unknown for companies to send threatening letters and litigate against their critics.
4. Personal risk. Expect blowback if you criticise a hot stock, and it is not unknown for people to receive threats and similar. US hedge fund manager David Einhorn was famously spied upon by Allied Capital, a ~billion-dollar company that illegally accessed his phone records, among other things.

Number 6: No-revenue hot stocks in Lithium, IoT, Crypto, Cobalt…et cetera

Where do I start?

I can’t tell you what to look for in an investment. But there are a tonne of things you should avoid, and you should approach all investments, especially in the smaller end of the market, with the assumption that you are the patsy at the table.

I have no financial interest in any company mentioned. This is a disclosure and not a recommendation. 

Picture sourced from the New York Bar Picture Book.

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