How to spot and avoid a "Wirecard"

Wirecard AG’s share price has fallen 94% from its 2018 highs with shareholders suffering an almost certain permanent loss of capital of €28bn since then.

What can investors do to spot and avoid other investment “potholes” that lie out there?

1. The first rule is to read the financial statements and be sceptical – if all it took was falling for the latest story at any price, we’d all be rich. Many investors spend more time researching where to go on their next holiday than on the financial statements of the company whose shares they want to buy. Don't be one of those.
2. It's hard for auditors to detect fraud so for this reason, I pay close attention to whistle-blowers and short-sellers, especially if they cry fraud and avoid any company involving either. No exceptions. Because there are good reasons to pay attention - whistle-blowers have little to gain and short-sellers have unlimited risk (stocks can only fall 100% but there is no limit to how much they can rise). As such, short-sellers often do a lot more detailed work than many long-only shareholders. A whistle-blower first sounded the alarm on Wirecard in Feb 2019 and the share price fell to €150 that day. Today it’s €15. "First loss, best loss."
3. Beware of complex business structures and highly acquisitive companies – bad things can happen in groups with lots of unconsolidated subsidiaries and associates. Amazon has only 5 subsidiaries, Microsoft has 8, yet Wirecard had 53. And if the subsidiaries are unconsolidated, the profit in one entity isn’t neutralised by the cost in the other. Steinhoff created fictitious profits this way. Tencent’s hundreds of Associates trade intergroup and while they state in note 21 of their Annual report, "The transactions with associates for the years ended 31 December 2019 and 2018 were considered not significant compared to total revenue in the consolidated financial statements," no mention is made about how significant the profit contribution was.
4.  Look at the balance sheet and what’s happening to cash and gross borrowings, not net cash or net borrowings. If they claim strong free cash flow but yet total debt is rising, be on guard. There may be a valid explanation, but it can be a red flag. Wirecard claimed on page 1 of their last published quarterly report that, "Free cash increased by 60%." Well, then why did long term debt increase by €300m in 9 months? We now know the answer - there was no free cash.
5. Be careful of charismatic and powerful CEOs who strut the stage sharing their visions of the future and their TAM (Total addressable market). If you Google “top Accounting scandals”, you’ll notice that most involved charismatic and powerful CEO’s. Too often investors confuse “impressive management” with charismatic leaders.
6. What is the CFO's qualification and standing within the organisation? I’ve noticed that most accounting scandals also involved “weak” CFOs, so in my opinion, if they are: young, inexperienced, unqualified, aren't a Board director but are lavished with share options, they may be easily influenced. Surprisingly not all CFOs are on the Board of Directors or even qualified as Chartered or Certified Accountants, and yet the Board makes important decisions on Buybacks and Acquisitions. Wirecard’s CFO isn’t a qualified accountant and the CFOs of Facebook and PayPal aren’t even board members. So be wary of a strong CEO and an easily influenced CFO.
7. Beware of related party transactions with executives– because I think they tell you something about the influence of the CEO and their attitude towards minority shareholders. Alibaba's related party transactions back in 2014 involving Jack Ma and AliPay are enough to keep me away from investing in the company.

There are thousands of companies to invest in so be careful and be sceptical. And if you don't want to do the required work, find a Fund you think invests cautiously and sensibly.