How to avoid getting crushed by stock fraud

Stock fraud handcuffs
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No one would have predicted at the start of 2015 that Valeant Pharmaceuticals, a Canadian drug giant, would have lost more than 60 percent of its share price in two months. But in October, short seller Citron Research accused the company of engaging in bogus transaction to inflate revenue.

While nothing has been proved and some people aren't convinced the company has done anything wrong, the damage has already been done — retail investors who owned this quickly growing stock, whether on their own or in mutual funds, have lost a lot of money.

If it feels like you've heard this story before, it's because you have. Over the last few years, many short sellers have accused companies of committing nefarious acts — Bill Ackman compared Herbalife to Bernie Madoff; Jon Carnes accused Silvercorp of misdeeds; Carson Block brought down Sino-Forest.

All of these stories have at least one thing in common: Blindsided investors end up losing big money. Many are also left wondering if there was anything they could have done. Why does it seem as though the professionals — fund managers and analysts — are caught as off guard about these kinds of allegations as the regular investor? And is there anything that can be done to avoid getting crushed?

Beware short sellers

In many cases, fraud is extremely difficult to uncover, especially when teams of analysts have numerous stocks to oversee, said Richard Teitelbaum, author of The Most Dangerous Trade: How Short Sellers Uncover Fraud, Keep Markets Honest, and Make and Lose Billions.

Long only-focused mutual fund managers also don't have as much incentive as short sellers to call out a company for fraud. In many cases, a mutual fund manager will see something and just not buy that stock, he said.

"They might get suspicious, but they're going to say, 'I won't pursue it' and leave it at that," he said. "There's not really an impetus to [devote resources to] push the matter further."

Some analysts also have an incentive not to call out a company for fraud, said Ryan Modesto, an analyst at Toronto's 5i Research, a retail investor–focused analysis firm that claims it's conflict-free.

In many cases, financial firms are courting companies for business, and a too-negative report could impact that relationship. Yet many investors don't realize that and often treat reports as gospel, he said.

Short sellers, though, make money when a stock falls, so they're actively looking into companies that may have problems. Some people do wonder if these firms are just saying things to cash in, but Teitelbaum doesn't think that's the case.

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"They're performing a public service," he said. "What they're doing is saying capital has been misallocated and that it's not a good place to put your money. To say they're manipulative is a poor defense on the part of companies who should be paying more attention to accounting regulation."

Investors should remember that anything can happen — a company can go bankrupt or fraud can occur — without warning. It's also difficult to catch someone who's purposely trying to game the numbers, said Teitelbaum. Remember how caught off guard everyone was when Enron went bust.

However, there are some things investors can do to better ensure they have a stock that's on the up and up.

Pay attention to the negative

Modesto may be a stock researcher now, but he learned about company fraud the hard way. When Sino-Forest was accused of fraud in 2011, the company stock tanked, but Modesto, then just a retail investor, bought in.

He thought he was getting a deal. Many institutional managers were still bullish on the stock, and he figured they must be right — after all, this short seller was relatively unknown at the time. That was a big mistake. The stock kept falling. He got out two months later, just before the company delisted from the Toronto Stock Exchange.

It was an embarrassing moment, but he learned a valuable lesson: Listen to the naysayers. Most stocks have one or two, if not more, analysts who have a negative rating on a company. Pay attention to what they have to say and see if anything stands out. Going negative isn't easy, he said, and many are going out on a limb to say what they really think.

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"It's your money and the buck stops with you. Do your research, and make sure you are comfortable with the company." -Richard Teitelbaum, Author

"Why are they so negative on the stock?" he asked. "Is there something there that you should have considered? In every market, there's a buy and a sell — you don't want to only look at positive information to back up a thesis."

Check the CEO's history

When you're looking into a company, check into the CEO's past. If they've made big mistakes in previous jobs, then it's possible that they'll make mistakes again.

Take Gaston Bastiaens, the CEO of Lernout & Hauspie, a speech-recognition technology company. The company went bankrupt in 2001 because of a major fraud, and he was eventually sentenced to three years in prison.

If people looked into his history, they may not have been surprised by what occurred, said Teitelbaum. In 1992 he joined Apple as a vice president to help launch the Apple Newton PDA, a predecessor to the iPad. The launch was a failure, said Teitelbaum.

In 1995 Bastiaens was hired as CEO of computer software company Quarterdeck, where he went on an acquisition spree that ended up hurting the company. He left the business a year later and joined Lernout.

"The companies that he had run ended up being disasters," said Teitelbaum, adding, "You have to ask yourself, How is this guy running a company? There's a saying about history: '[History] doesn't repeat itself, but it rhymes.'"

Watch out for serial acquirers

It can be harder to catch a fraud if the company is rapidly acquiring companies, added Teitelbaum. It's much easier for executives to hide a lack of organic growth when a business is growing rapidly through M&A, he explained.

Of course, not all acquirers are hiding something, but these operations do require some additional due diligence, said Beth Hamilton-Keen, the CFA Institute's chair of the Board of Governors.

Pay close attention to leverage, she said, noting that many acquirers, including Valeant, have taken on a lot of debt to finance all of their buys. As purchases get more and more expensive, it can get harder for the company to "digest" that debt. As a result, these companies need to generate higher and higher returns on these acquisitions.

In many cases, these rapid acquirers have accounting reserves, which a company can set up when it buys another business in order to pay for costs, such as business integrations and layoffs. It's legal to do, but most people don't track them, said Teitelbaum. As more accounting reserves are set up, "they become more and more difficult to keep track of and can be used to bolster earnings when needed," he added.

Dig into the footnotes

It's important to read every part of a company's quarterly report, but especially the footnotes, said Teitelbaum. Many companies bury bad news, such as special charges, nonrecurring items or an acquisition gone wrong, in the fine print.

He remembers when AOL once buried in its footnotes that it had to buy back a stake in AOL Europe for a "phenomenal amount." The analysts didn't catch it, he said, "but there it was, and it was meaningful information."

Ultimately, it's hard to catch bad companies doing bad things, but when it comes down to it, read as much as you can about a company and trust no one, advised Modesto. When he buys companies, he makes sure to put in the work himself.

"It's your money, and the buck stops with you," he said. "Do your research, and make sure you are comfortable with the company. Use analysts and all other information sources, but don't defer any responsibility onto another person. It's a tough lesson, but it's one I've learned."

By Bryan Borzykowski, special to CNBC.com