Clapham, who runs the investment research and training consultancy Behind The Balance Sheet, has worked on both the buy- and sell-sides in his career. Martin Hughes, the hedge fund tycoon known as "The Rottweiler", hired him in the mid-noughties to become a partner at Toscafund Asset Management. Clapham then moved to the hedge fund Altima Partners to become head of research.
Behind The Balance Sheet trains analysts and investors in forensic accounting, among other things. Clapham has also recently published a book on his work called The Smart Money Method.
Clapham is known for digging deep into companies' accounts. He looked into Patisserie Valerie, for example, the UK café chain championed by the British entrepreneur Luke Johnson. Clapham, whose child was a peer of Johnson’s child at school, said he found accounting fraud in a matter of minutes.
Just recently, he started researching the Chinese internet companies Alibaba, Baidu, JD.com, Meituan Dianping and Tencent. He argues that it is hard to truly understand these companies as their accounts are so opaque.
He offered GlobalCapital an insight into the ease with which companies can polish their accounts, and how little scepticism there is in investment circles.
GlobalCapital: You make a habit of emphasising the importance of the balance sheet and I was wondering why that is, and also perhaps more importantly why other people might overlook it?
Steve Clapham, Behind The Balance Sheet: Well, there's a clue in the name of my company. The reason I look at the balance sheet is there's a huge amount of information there. It's the most informative of all the financial statements.
The balance sheet is absolutely overlooked by the investment community, less so on the credit side but certainly on the equity side.
I can illustrate that very clearly for you. Vodafone is one of the few UK companies that makes available to the sell-side a spreadsheet of their financial data. That spreadsheet has 15 tabs but it does not have a balance sheet. Yet Vodafone is the only company in the FTSE 100 that I'm aware of that has a price to book ratio of under one and is not a bank.
You would think that investors would think the balance sheet was quite important, but nobody's interested. I asked two investors in Vodafone what they thought of the balance sheet, and neither one had even looked. This stock is on a discount to book, so who wouldn't look at the balance sheet? It just defies any rational explanation. The fact is that people don't spend enough time looking at accounts. Equity investors just ignore the accounts, they are completely story-driven.
Does this not speak to the ease with which companies can falsify accounts? If you were a CFO of a European manufacturing company, and you wanted to falsify your numbers to inflate the value of the company, what would you do?
OK, so how would you like me to do this? I mean, I can inflate the revenues because I can make them up or bring them forward. I can reduce the expenses by making provisions too low, by deferring expenditure, and by capitalising expenditures.
The first thing I would do is R&D. I'd capitalise R&D and immediately, which would benefit not just my earnings number but also my cash flow, because R&D is no longer deducted from operating cash flow — it's now capital expenditure. So I mean, it is so easy.
How often do you come across companies that aren't totally falsifying the numbers, but just engaged in very, very aggressive accounting?
Well, a few years ago I was going round small cap companies trying to drum up business for Hardman & Co, and almost every single results meeting I went to gave me an example for my forensic accounting course. I did not attend a single analyst meeting where they weren't cheating or where I couldn't find something.
It’s incredibly widespread. I mean, Berkshire Hathaway: clean. Second one, I’ll get back to you.
What’s interesting is that in the most high profile modern accounting frauds, what is under-emphasised is just how easy they should have been to detect.
Take Patisserie Valerie. There were so many ways you could have spotted it.
So many things puzzled me. First the auditors — where were they or what were they doing? Second is the banks. HSBC lent them £10m and you would think they'd have looked at the accounts. Its loan was not on the balance sheet.
When Patisserie Valerie first announced difficulties, I was asked to speak at a private investors' conference and I went along and there's a room full of 350 people. I asked if any of them owned Patisserie Valerie stock and about 10% of them put their hands up. That’s a lot of people. Anyway, I went through my presentation and they all looked a bit sheepish because I showed how obvious the fraud was.
The auditors have been asleep at the wheel. The auditors’ policeman [in the UK and Ireland] is the Financial Reporting Council and if you ever go onto their website, it is not exactly user-friendly, but I managed to find their report on the auditors.
Anyway, the auditing body has a standard classification — 1 or 2A — which they say 90% of FTSE 350 companies when tested should reach. I don't even know what 1or 2A means but I can guarantee you it is not gold-plated.
The FRC states that only 73% of FTSE 350 companies reach that standard. The auditors are almost 20% short their own standard.
Some think that’s negligence, and others think it’s complicity.
Look, the legislation is quite clear, the auditor is not responsible if there's a fraud.
In the case of Patisserie Valerie, where the finance director has been actually falsifying the books and doesn't tell you about a loan from HSBC and another bank, there’s not much auditors can do short of writing to every bank in the world. Auditors rely on management telling them about all the bank accounts.
But none of the big frauds that have happened have been that difficult to spot. I just don't think they do the job properly.
I’ll give you an example. Someone I know is working on a new business project and he's brought onboard his mate, who was very senior in one of the big four accounting firms.
I looked at the project and said the numbers aren't right. My contact said no, this senior auditor said it was fine. It took me 20 minutes to look at it and notice the numbers are so out of sync with the peers that it’s just nonsense.
The senior auditor thinks he's really super-smart but he's an idiot. He's got no clue about how to audit a company. He might have been in charge of auditing loads of companies, but he's got no real ability to interpret a set of accounts because he's never been trained to do so.
What are the biggest red flags that mainstream forensic accountants find?
My top three are margin comparisons, cash flow versus earnings, and working capital.
The working capital ratios often tell you something's wrong, because if you're faking sales it’ll end up pushing up one of the receivables.
With Patisserie Valerie, the margin comparisons could have told you in five minutes that the numbers were rubbish. I mean, just ludicrous.
For example, Patisserie Valerie’s margins kept going up or were flat and the Café Nero margins were going down like a stone. A lot of Patisserie Valerie’s appeal was that they had shiny management which impressed investors. They had a ‘we can trust Luke’ [Johnson, the cafe chain's chairman] mentality.
Lastly, I’d be foolish not to ask you about Chinese internet companies, and how tricky their balance sheets are to read.
I was interviewed by Kyle Bass [who runs Hayman Capital Management] recently, and his view is that Chinese companies are totally uninvestable because you don’t know what rights you have over the assets. This is a very valid argument, although I think you can invest up to a point, because the chance of you having to enforce your rights to the assets in a Chinese court is limited.
But as far as the balance sheets are concerned, they are incredibly opaque and I doubt that anybody who owns the stock has actually done the work we've done on them. Because when you do, it's very clear the balance sheets aren't accurately stated. So maybe there will be a reckoning at some point, when these companies have to take massive writedowns.
With Alibaba, there are total assets of $180bn and $50bn of these are questionable assets.
Interestingly, Amazon has got assets of about $200bn, so very similar size boundaries. Alibaba has got $15bn worth of property and equipment and Amazon has got five times that. But Amazon has got five times revenue. So those numbers probably are OK.
With Alibaba, there are $50bn of investments and $49bn of intangibles, including things like non-compete agreements, which I've never seen on any other balance sheet.
Investors are not interested in the truth, because the truth would be too painful. I'm selling my report for $5,000, which has fresh and damning research on Chinese tech companies. You would think I'd be a rich man, right?
Alibaba did not respond to questions from GlobalCapital in time for this article.