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Too good to be true: Basics of financial skepticism

Special to The Globe and Mail

The case of Bernie Madoff, the New York hedge fund maestro who has been accused of looting or losing $50-billion (U.S.) raises the question - how could pension funds, well-advised charities and uber-wealthy private investors have been fooled for so long?

Mr. Madoff claimed to be able to achieve high fund returns when others could not, smooth stock returns in rough markets, and options trades in volumes greater than exchanges reported to exist.

In retrospect, his claims demanded investigation, yet he usually got away with saying that he had a proprietary trading system that he would not discuss. The alleged ruse worked for what appears to have been a decade because, simply put, the victims chose the prestige of being in his funds rather than doing their due diligence. And then his claims turned out to be too good to be true.

It's not the first time that investors have been duped into believing a story that was statistically unlikely and, in accounting terms, unfathomable.

ONCE A MARKET DARLING

The dot-com fantasy came apart in 2000 as investors realized that paying a few hundred times earnings was not the way to prosper. The tech market had decided that the "burn rate," i.e., the pace of destruction of capital would be proportional to future profit. It turned out that burning up capital was the way to insolvency. The market had come to its senses at a huge cost to former believers in a financial concept akin to the idea that pigs can fly.

Don't forget Bre-X Minerals Ltd., the gold mine scam in Borneo in which alluvial gold from a river bed was salted into samples, amid claims that the find was the largest gold deposit ever, with estimates growing day by day. Shares rose from pennies to $286.50 before the fraud was undone by an analysis carried out by potential buyer Freeport McMoRan, a U.S. mining giant. It turned out that there was no significant gold at all.

Before that, there was the handiwork of junk bond magician Michael Milken. He promoted the idea that low bond ratings should be no barrier to investment.

If a bond portfolio had a default rate of 8 per cent and the bonds in it paid 20 per cent more than Treasury bonds, you could take a hit and still win.

Trouble was that the 8 per cent was the rate at which defaults occurred each year. But a junk bond's odds of default over its lifetime until promised redemption was in a range of 20 per cent to 50 per cent or more. That wiped out the gains.

Mr. Milken pleaded guilty to a variety of securities violations in 1990. He got slapped with a record fine of $200-million (U.S.) and paid another $400-million to investors he hurt.

He served 22 months before being sprung by ace appeals lawyer Alan Dershowitz.

Long before Mr. Milken, there was the classic Ponzi caper of the 1920s in which later investors' money paid off early entrants, all of whom believed that they could get rich by speculating on postage coupons. Charles Ponzi had promised a 50-per-cent return rate in 45 days or double that in 90 days. Allegedly, Mr. Madoff appears to have revived it, though with somewhat less brazen claims.

Each of these cases is bound together with a single thread - investors abandoned their duty to clients or to themselves to check claims and, instead, adopted the widespread passion for the asset, reasoning that the market could not be wrong when an asset was so big.

"People fall in love with an idea that they do not understand when they hear that a neighbour or someone they know makes a lot of money," says Carolyn Nalbantoglu, a registered financial planner with PWL Advisors Inc. in Montreal.

"Trust is the product of envy and it leads to leaving logic behind. You should never fall in love with a stock. It is only a tool to make money."

Investors can take steps to protect themselves.

Robert Klueger, a tax lawyer in Los Angeles who wrote Asset Protection (Entrepreneur Press, 2008), suggests ways of insulating a portfolio from harm.

"What makes the Madoff case unusual and what should have been a red flag, was not his returns, but the lack of transparency," Mr. Klueger says. "There were individuals or charities that invested with intermediaries like funds of funds or financial planners and they, in turn, invested with Madoff. Part of the cachet of Madoff was that his fund was opaque. Those who asked questions were not allowed in. Anyone who was nosy was thrown out."

THE WISDOM OF DISBELIEF

Every investor should ask a single opening question when considering any asset: "How does this thing work?" suggests Jackee Pratt, vice-president at Mavrix Funds Management Inc. in Toronto. "If you can't figure it out, then stay away."

The corollary to Ms. Pratt's rule is that the more exceptional the return, the more curious the investor should be about what drives it.

For mutual fund investments, look at what a manager owns, Ms. Pratt suggests. Then look at what the portfolio stocks did. If the manager has a bunch of ordinary stocks up 1 or 2 per cent, you have to ask how he managed to have high performance. It can be concentration on a winning name like non-ferrous metals producer Timminco Ltd., a penny stock in early 2007 that rose to $35.69 in June, 2008 and that has tumbled 83 per cent to a recent price of $3. Having too much of a fund riding on one name amounts to risk concentration. It may not produce durable performance, Ms. Pratt warns.

DECEPTIVE ACCOUNTING

Accounting can make the difference between fact and fiction. But all accrual accounting, which means transferring expenses and revenues from one period to another, is a potential minefield of deception.

"There is nothing wrong with accrual accounting; it is supposed to show where a company is going," explains Charles Mossman, associate dean of the Asper School of Business at the University of Manitoba in Winnipeg. "But where earnings are manipulated to meet targets, it is deceptive."

The most common ways of fudging the books are by accruing revenues where they have not yet been earned or delaying expenses, usually by capitalizing them, or by shifting them to special entities off the books entirely, Professor Mossman says.

There are other flags the investor should watch for, Ms. Pratt says.

"An auditor does not sign off on an annual report or gives a qualified opinion - that's a sign of problems. And if the chief financial officer resigns without reason, you better find out why. Finally - and it has happened - if the CEO is indicted, don't invest. Of course, by then, it is usually too late."

This story first appeared on Globeinvestor.com/magazine.

© 2007 The Globe and Mail. All rights reserved.

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