I was recently asked by a friend how to detect potential problems in companies like Luckin Coffee, Hin Leong Trading etc? Before investing, how do we detect if there might be fraud or risk of failure?
People like Muddy Waters, Jim Chanos are very granular because that is all they do. Most fund managers will not be able to go to the kind of granular on the ground research that they do. But, there are some high level signs I look for:
1. Always start with the balance sheet. ESPECIALLY the assets.This may sound counter-intuitive, but most companies are not able to hide what they owe other people, because there will be invoices and letters of demand etc. BUT, they could exaggerate what they OWN, because no one is likely to check that.
If you claim that Company XYZ owes you money, Co XYZ may not even know about it and won't do anything about it. So look for suspicious levels in Accounts Receivable, Inventory, even excessive cash levels.
Some companies could use the cash for other purposes and take it out of the company, and then put it back in the account on balance sheet date (eg 31 Dec 2019) so that when auditors write to the bank to confirm the bank balance as at that day, it will be affirmative.
Obviously, if the balance sheet is weak, we should not even consider the company in the first place. But that is usually detectable, what we are concerned with are the ones that APPEAR to be strong because they have a lot of assets, but actually are very weak.
2. How is the company using the cash?Historically, has the company been able to return more cash than they have taken from the market? Most crooks will want to make use of the cash and not return it to shareholders.
These are just some quick tools I usually use. What do you use?