Ted Seides, founder of the Capital Allocators podcast, and founder, president and co-CIO of Protégé Partners LLC, shared with us why it is so challenging to detect fraud.
There are a few main challenges:
- Usually, we spend 99% of our time assessing the merits of an opportunity but 1% of our time thinking if what we see is real. The fraudster spends 100% of their time staying two steps ahead of you.
- Not all frauds started that way. Some became frauds to cover up losses.
Recently, there have been more frauds because, in the start-up world, the environment encourages that.
We often say that periods of significant challenges are also periods of great opportunities.
This means that if there are great investments that potentially give outsized returns, the attributes also lead to fluff and overpromised ideas.
Ted then shared with us how he could not detect certain frauds and suffered through them as well:
My whole academic and working life leads me to believe that some things are not black or white. Sometimes, I would ask myself:
Kyith, if you discover a great opportunity but it sits on a gray line between right and wrong, which path would you take?
You know, I don’t have a good answer for that.
Some stuff we do is what we hope to alleviate a problem temporarily, but eventually, the dominos lead to the point of no return.
I would like to believe that my sophistication in fundamental analysis, experience in reviewing multiple companies and how enough books were cooked would make me better than most to avoid fraud. I would avoid it enough, but fraud is not the only stuff that would make us lose money.
Believing in the overhyped intrinsic value of businesses is not outright fraud but can impair our capital.
As I invest longer, I have become blunt in this area or was lucky to have averted them in the past. There were enough instances where I looked to invest but didn’t that turned out to be disastrous. If I am truthful, I did not detect the causal factor of the collapse.
Given the time that I can invest in doing due diligence, I prefer to err on the safe side to put a limit on my conviction by forcing diversification to prevent large capital impairment.
Ted Seides gave the following advice:
- Recognize that fraud is fraud.
- Stay vigilant. What ends up as fraud may start as a legitimate business.
- When in doubt, stay out.
- Diversify prudently anyway.
Byrne over at the Diff summarizes a recent paper which looks deeply into frauds.
Firstly, the paper notes that fraud is cyclical. Today, we have fewer public frauds.
The equilibrium for fraud is set by two forces:
- How rewarding it is for companies to engage in it.
- How rewarding it is to catch it.
Byrne thinks that fraud is a human problem and not just a problem of account standards. If it is harder to commit fraud in public markets, then where do fraudsters go?
The environment is more conducive to committing fraud. That is the base rate.
Lastly, while I find people boastful about returns annoying, people who are high and mighty only dare to talk about how frauds were so obvious only when things are revealed to be just as annoying.
But from the expert, those who are most susceptible to fraud are those who, in their minds, are most unlikely to suffer from it because they are just too good.
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