Taken together, it’s a reminder that it’s difficult enough to “learn lessons” from crises, but it’s extremely hard to actually implement changes. We would even point out that when changes are implemented, it’s not always an improvement… This means that the door is still open for human behavior + twisted incentive systems that eventually use these loopholes to create havoc. Recognizing this and controlling oneself is the first step to trying to take advantage of this.

LINKS:

Fraud detection: Red flags – a KnowledgeLeader “checklist” of sorts that is just that – a list of useful tell-tale signals or warning signs. As we said above, it shouldn’t be taken too seriously.

No one would listen – A Buysiders.com post about Bernie Madoff, whistle-blowers and red flags that remained ignored for way too much time. By the way, we’d now add another book suggestion to the ones we make in this post: The Confidence Game, recording Bill Ackman’s saga against MBIA Corp.

Essentials of Corporate Fraud – We’re not singling out this book as a leading publication on the subject, it’s just a way to open up “related book” searches. There are many many textbooks on fraud, forensics accounting and so on, and this didn’t necessarily save people from Enron, Worldcom, Madoff, etc. – and won’t necessarily prevent the next, big, “unimaginable” fraud either.

US agencies’ fraud-detection effors – As this Federal Trade Comission page shows and other pages not mentioned here corroborate, the US government is very concerned with fraud and tries to increase awareness of the issue. This handbook about the Red Flags Rule for protecting consumers’ IDs is an interesting read.

The main takeaway is, as Mr. Musacchio points out in the interview about his book, that “If investor protections are weak in national laws, companies can offer protections in their bylaws that compensate for those weaknesses. It is easier to change a country one corporation at a time than trying to change legal practices. Once many corporations adopt strong investor protections in their bylaws, others have to follow.”

While the author does note that Brazilian CG has improved in the last few years, he also points out that in some aspects we’re now behind this “strange Brazil” of the turn of the 20th century. Here’s hoping that competition for (increasingly) global funding sources and the shock value of the latest confidence crises around the world do help the overall system evolve faster.

LINKS:

How to order the book and some reviews

The book’s Introduction (in PDF, 27 pages)

We’ll never get tired of saying this: dump the checklist approach to CG. Actually, dump the checklist approach to anything.

Corporate Governance and alignment of interests is about so much more than the proportion of “independent” directors or separate CEO and Chairman roles and so on… It’s like saying that Berkshire’s governance lacks substance because “Buffett is both Chairman and CEO and keeps family and friends in the Board” without digging deeper – and by the way, many people do say this. The fact that Buffett only takes home US$ 100,000 in annual salary with no stock options and has about 99.7% of his net worth tied to Berkshire stock (all of which he purchased directly in the market) goes unnoticed. The percentage of stock owned by WB, Charlie Munger and Buffett relatives amounts to so much of the company that it’s like having a saber-tooth tiger as a watchdog for minority shareholders.

There’s lots of interesting content in Amazon.com’s launch page for “No One Would Listen”, the book by Harry Markopolos – the main whistleblower in the Bernie Madoff saga. The timeline in particular is very impressive: it shows that all in all it took ten years to uncover the mess – nine since the first contact with the SEC – by which time the problem was irreversible. And that’s far from the only case, which begs a question…

Apart from the “I want/ need to believe”-type mental traps that individuals fall into, how do we justify still having institutions supposed to keep watch so unready and unwilling to investigate red flags? Lack of funding, qualified personnel, IT infrastructure… they all seem like weak arguments even put together.

We won’t go into the Taleb argument that one must be highly skeptical of “results”, and let’s not recall the Bob Rubin “focus on processes, not outcomes” (great) advice. Let’s just highlight two other books on fraud or lack of oversight – one caught, one still perhaps on the loose.

The most Madoff-like story is David Einhorn’s Fooling Some of The People All of The Time, about his years-long struggle with Allied Capital. Again, the pattern of ignored warnings is troubling, and while the story eventually played out to Mr. Einhorn’s thesis (see the 5-yr chart here), it wasn’t due to regulatory action – the credit crisis almost did the company in.

The other book is a quick read – Barry Minkow’s Cleaning Up – about ZZZZ Best, the company he founded and took public as one of the youngest persons ever to do that (remember that this is quite pre-dot.com days!). Nice story, if it wasn’t all a Ponzi scheme, and one that also took a while to uncover. Since this account is in first person and Mr. Minkow later helped the FBI uncover several corporate frauds, it’s pretty interesting lore. We’ve watched the guy live in the first Value Investing Congress and he’s a decent speaker as well.

UPDATE (March 19th, 2010): Nice and funny video interview with Mr. Markopolos on Jon Stewart’s Daily Show.

Highlights:

On accountants: “A majority of the horrors we’ve faced would not have happened if the accounting profession were organized properly.”

On the actions taken in the middle of the crisis: “The problem is so extreme that nothing “un-extreme” has any chance of fixing it. So I basically applaud the people in the government that are doing these extreme things. I’m sure they’re making a lot of decisions that in retrospect will be seen as mistakes, but given human condition where they have to do extreme things under fire, I’m not inclined to criticize them.” (…) “I’m happy to see that the Obama administration has brought in Larry Summers, who is a ferociously smart man and will try to do the right things even if it offends some people.”

On what needs to be done in the US: “Not only do we have to save the financial system, (…) but we also need a huge spending stimulus from the federal government… I don’t regard that as all bad at all, there’s so much that needs to be done in this country. We need a whole electricity distribution system (…) Much can be done in medical care. The hospitals in this country are about to get a vast improvement in its facilities and that’s all for the good. (…) The dangers from what we have to do are less than the dangers that would plainly come if we responded as we did in the 1930′s.”

On the US allowing Lehman to fail: “It was not a mistake. It actually helps to have one or two go (…) You have to have a loud failure.” - he did have to think about it a lot before he actually said it, though...

The numbers that matter: US$ 131Bi in equity, US$ 62Bi in float => ~ US$ 193Bi in “capital”. Book value grew 20%. Float grew 5.8% (from US$ 58.5 to US$ 62Bi). All insurance businesses operated with underwriting profit again. Cash = US$ 30Bi (US$8Bi used in Q1 to pay part of the BNSF deal). Operational assets = US$ 30Bi but generated only US$ 1.1Bi in net profits, which shows insurance/investments did the heavy lifting. The operating units will hopefully make up their fair share of contribution in a recovery.

Bottom line: investors are still paying about capital value at current prices. It has the best governance we ever saw. If they continue to grow float, have underwriting profits and make good investments, it’s a steal. Never mind the recovery.

We don’t have any intention to be the “ultimate source for all things Buffett”, as a lot of people already do a great job at this and we thank them for uncovering these pearls. But this video is special. The parts on “moats” add up to some of his most detailed comments yet on the subject.

We don’t think it’s any exaggeration to say that Buffett has transcended the investment realm and that this is interesting for people in all walks of life. We’re certainly making backup copies.

Price is the key, and many investors forget that it’s not enough that the business is great and the managers competent and even that the company has the “outside signs”/ usual “seals” of corporate governance or credit ratings – or even environmental best practices – when it comes to estimating a range of values… Corporate governance and alignment must be great in the real world. Unfortunately, that is very hard to find and hard to quantify, so those seeking algebraic approaches to long-term investing do so at their own risk.

Which takes us to “Anti-portfolio one”. This comes courtesy of a reader who was discussing precisely the issue of price with us a few days ago. Then he found a pearl of an article in the New York Times dated February 20th, 2000 – the peak of the Internet/ Nasdaq bubble – where a few managers listed their chosen stock to own until January 1st, 2010. That is, if you could own only one stock from early 2000 for the next ten years, what would it be?

The answers are interesting because a few of these companies haven’t survived, one was the object of a major accounting scandal, and so on. But we don’t want to focus on the companies themselves, but on the reasons given, the “case” made at the time. The arguments, especially regarding the earnings multiples at the time, seem preposterous and could be dismissed as “bubble talk”, but recent years have proven that we don’t learn this kind of lesson easily… And we go back to the point of price: yes, multiples can be misleading, but regardless of the measure, the price you pay has to take into consideration that even the best-planned strategies executed by the best managers can go wrong in too many ways.

In the other corner, “Anti-portfolio two” was found by our Healthcare analyst when he was researching a relatively newcomer to the sector and found that traditional VC firm Bessemer Venture Partners was one of the seed investors. The firm itself built an “anti-portfolio” section in their website that, well, has to be seen to be believed – and still Bessemer has done quite well… This example is about what Buffett calls “sins of omission” – he often mentions Wal-Mart, which he tried to penny-pinch and ended up losing “Billions” over time as the company became the behemoth it is today.

Finally, we’d like to thank our reader and urge others to follow his example! As always, send us your suggestions via the e-mail editor@buysiders.com .