Profiting From the Frauds (Legally)

Don’t get fooled by the frauds, take the money and run.

Profiting from the Frauds

In the 50 years that Cabot has been providing investment advice on fast-growing young companies, there have been three occasions when stocks of companies run by crooked executives fooled us (as well as other investors and auditors) for a while.

The sad part of these stories is that in each case, many individual investors were hurt; having bought high, they were left sitting on big losses when the financial frauds were uncovered.

The happy part of these financial frauds is that they are few and far between—and sometimes, investors can make very good money in these stocks before the fraud comes to light.

Financial Fraud #1: ZZZZ Best
The first, in 1987, was ZZZZ Best, a small California company run by Barry Minkow, a brilliant but ethically flawed individual. (He was later diagnosed as having antisocial personality disorder, narcissistic personality disorder, attention deficit hyperactivity disorder, anxiety disorder, opioid dependence, and anabolic steroid abuse.)

The company started as a legitimate carpet-cleaning business while Minkow was in high school, but after expanding into insurance restoration, the company increasingly became a giant Ponzi scheme—which looked great on paper. The paper fooled enough people that in 1986, Minkow became the youngest person to lead a company through an IPO in the history of Wall Street (he was 20 years old). And soon after, ZZZZ Best’s stock ran from 3 in January 1987 to 17 in just three months—achieving a market cap of more than $200 million. But two months later as the fraud unraveled, the stock was down to 6—and two months later it was near zero.

Sentenced to 25 years in prison in 1989, Minkow became a born-again Christian while inside, but a few years later, as an ordained minister, he was sentenced to five years for defrauding his church! He was released from prison last June. (Note: ZZZZ Best was written up only once by Cabot back then and was never in a Cabot portfolio because we were in a bear market and holding cash when the stock was hot.)

A movie on Minkow’s colorful life, titled Con Man, was released in March 2018, to very mixed reviews.

Financial Fraud #2: Centennial Technologies
The second notable financial fraud was in 1997, when Centennial Technologies, a Massachusetts manufacturer of PC boards, was found to have “cooked the books.” At the heart of the scheme was CEO Emanuel (Manny) Pinez, who was fired by the company’s board in February 1997 for falsifying inventory reports and inflating sales figures. Three days later he was arrested by FBI agents and sued by the Securities and Exchange Commission for stock fraud.

Centennial had come public in 1995, and the stock was the top performer on the NYSE in 1996, up 447%. Before Pinez was fired, the stock had traded at 55 in the hot technology stock bull market. But trading was halted and when trading resumed, the stock was at 3. Four months later, after digging through the numbers, management revealed that Pinez and his allies had inflated profits by $40 million over 3 ½ years.

In 2000, after a trial, Pinez was sentenced to five years in jail and fined $120 million. Centennial stock had been in the portfolio of our Cabot Market Letter (now Cabot Growth Investor) since November, and had a 72% profit at the top, but the bottom fell out so fast that it was impossible to get out unscathed.

Financial Fraud #3: Luckin Coffee (LK)
And now, in 2020, we have another financial fraud in Luckin Coffee (LK), a Chinese company that purportedly ended 2019 with 4,500 coffee outlets in China, a number larger than Starbucks.

Luckin came public in May 2019, and the stock was up 157% by this January, peaking at 51. Our Cabot Global Stocks Explorer had recommended the stock at 18, soon after the IPO, so some readers had even larger profits!

However, chief analyst Carl Delfeld knows that trees don’t grow to the sky; he repeatedly told his readers to take some profits off the table. And then the bottom fell out of the stock on April 2, after the company announced that it had suspended COO Jan Liu and several employees reporting to him for misconduct related to “fabricated transactions.”

Maybe there aren’t 4,500 outlets. Maybe there are. What we do know is that the company stated, “The information identified at this preliminary stage of the Internal Investigation indicates that the aggregate sales amount associated with the fabricated transactions from the second quarter of 2019 to the fourth quarter of 2019 amount to around RMB2.2 billion.” In U.S. dollars, that amounts to about $310 million—which is greater than the revenues previously reported (apparently falsely) in the third quarter alone.

After the fraud was exposed, LK stock fell for three days, and then trading was halted (pending new information from the company)—so now investors who didn’t sell are stuck, with the stock 91% off its January high—and hoping that the truth (when it emerges) is enough to lift their stock at least partially out of this deep dark well.

Also, in time we’ll get a look at how the Chinese justice system treats con men—or maybe we won’t.

So, what have we learned?

  1. If you invest/trade in young, fast-growing companies, there’s a small risk (very small) of falling for a con. For Cabot, three cases (only two of which were actual recommendations) in 50 years is not bad.
  2. Frauds are not limited to small companies; even if you invest in big companies, you can still fall for a fraud. Famous cons in this time have included Enron, Worldcom, Tyco and HealthSouth, all of which we avoided—and of course Bernie Madoff.
  3. You can actually make money in these frauds if you’re quick to take profits when the stocks are high. Remember, bulls make money, bears make money, pigs get slaughtered.
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