How Trend-Following Can Save You From Fraud
Now and then, we see companies originally seen as superstars turn out to be frauds. Companies are simply a reflection of the people running them and so we should not be surprised by this. However, as simple layman investors without access to the insiders in the company, how are we to judge whether the companies we invest in are frauds? Sure, there are usually signs before the company gets busted. Smart dedicated journalists and short-sellers would usually sound the alarm but they are not always right or successful in bringing down the company. For example, Bill Ackman lost his bet against Herbalife. Furthermore, the short-sellers have a financial interest to bring down the company. Having said that, if the company we invest in really turns out to be a fraud, we stand to lose everything we invested in that company.
One of the strategies we teach is a simple trend-following approach to investing in stocks. Although simple, it is effective in protecting against such a scenario playing out. Let's take a look at some examples. Most frauds get exposed around the time of a recession. This is because easy money during a bull market can easily cover the tracks of fraudulent activities but when times are bad, it becomes harder to perpetuate such schemes. Add to the fact that during good times, investors are more forgiving as long as stock prices are going up but they start to scrutinize more when things are going down.
In the late 90s, Enron was the darling of Wall Street. Fortune magazine called Enron “America’s Most Innovative Company” for six consecutive years. But it all turned out to be a mirage as Enron engaged in dubious accounting methods that allowed them to recognize future profits. When the tech bubble burst and the global economy went into a recession, most of the future profits evaporated and even turned into losses. Everything came crumbling down and the fraudulent accounting method was exposed. In the end, Enron went bust and the stock became worthless. If trend-following was used to invest in Enron, you would have exited before Enron collapsed and still made money from this fraudulent company.
If you had invested in Enron since 1998, you would have turned US$100k into US$258k. You would have more than doubled your money in less than 3 years.
Wirecard is the most recent fraud on a big scale. This time, it happened in Germany. Wirecard is a digital payment company and presented itself as a FinTech company. German politicians were very proud of Wirecard because it was seen as a home-grown modern successful company when compared to the other old-school companies like the auto companies and traditional banks. In 2018, Wirecard even joined the DAX blue-chip market index, making it officially one of the 30 most valuable German companies listed on the Frankfurt Stock Exchange.
As it turns out, Wirecard also used fraudulent accounting methods to cook up fake revenues. It was even a front for money laundering and other illegal activities. Right before the game was up, the CEO even considered taking over Deutsche Bank so that the bank's balance sheet can be used to cover up the stench in Wirecard's balance sheet. In the end, all it took was for Wirecard's auditor EY to refuse to sign off Wirecard’s 2019 accounts as it was unable to confirm the existence of 1.9 billion euros in cash balances on trust accounts, representing around a quarter of its balance sheet. This was the nail in the coffin for Wirecard. Again, if trend-following was used to invest in Wirecard, you would have made money.
If you had invested in Wirecard since 2003, you would have turned 100k euros into 494k euros in less than 20 years. All from a criminal company!
Trend-Following Is Not Magic
Before you get all excited thinking that you have found the holy grail to investing, let me clarify that there are some trade-offs to trend-following. As can be seen from the Wirecard example, trend-following tends to underperform buy & hold if the stock is in a bullish trend marked by intermittent sharp pullbacks. This is the nature of trend-following as it tries to protect capital. However, if you use trend-following on a diversified basket of stocks, the law of large numbers should start to work in your favor. More importantly, you need not worry about fraudulent companies anymore.
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