I am writing this article to help retail investor to identify Corporate Governance issues or fraud in particular Stock as well as impact of that corporate governance issues or fraud in particular stock in the long term. If you are expert and know very well about corporate governance issues or fraud then you can skip this article or add your input in comment section.

               Retail investor listens term corporate governance lot of time but not able to understand corporate governance in depth . If we go through any of the company’s annual report then there will be report on corporate governance and mostly it would have mentioned that we follow highest level of corporate governance standard but we have to check , does it really follow highest standard of corporate governance ? We, as retail investor have to identify Corporate Governance Level followed by the company , then only invest in that company. I believe corporate governance level check is first criteria then check for other valuation criteria. 

               Being a value investor, we try to find cheapest available stocks , sometime we use some magic formulas as well. If we analyse Indian stock market then you will come across lot of cheap stocks but cheap stock does not automatically qualify as value stock . We have to pick value stock from lot of garbage cheap stocks available in stock market. Half knowledge about value investing is more dangerous than no knowledge about value investing. Since , if one do not know anything about equity stock analysis he may choose to go through relatively safe root of mutual fund ,else he may consider some of dirt cheap stock as value stock which are in reality value trap . Whatever methodology you follow to choose value stock , follow it ,but  first you should check corporate governance level . I mean to say if corporate governance level is quite low and company looks quite good candidate for a real value buy on other value buy parameters , then we should avoid this stock.

               How does promoters cheat investor ? how fraud happen in the company  ?

              

               Promoter can cheat investor in n number of ways and they will continue to invent new ways to cheat . I have identified following ways to cheat investor with symptoms to identify it . Please note that these symptoms are starting point to identify corporate governance issues or fraud and it is not end point . These symptoms should be analysed with other factors .

1.      Manipulated profit type-I:- Company is showing good growth in Profit (PAT) without actual cash generated by the company.

Symptoms :- We can identify this type of fraud by analysing cash flow statement along with P&L statement . If a company shows good PAT number but same is not translated in “cash flow from operations” then that is alarming sign . Please remember this is starting point of your analysis for identifying fraud company and not conclusion .

To be sure, negative cash flow from operations isn't always bad but in Indian stock market context it is bad in most of the cases.

               There is cash flow statement section in every annual report where “Cash Flow From Operating Activities” figure is arrived from adjustment in PAT figure . e.g. Depreciation, Inventories, Receivables  etc.  One should determine the source of the cash haemorrhage then come to any conclusion . This can be itself covered in one article itself.

2.      Manipulated profit type-II:- Company is showing good growth in Profit (PAT) with positive cash flow.

Symptoms :- This type companies shows good growth in Profit , even cash flow is positive .So get skips from earlier mentioned fraud category. However, in  this category you will see low Debtors' Turnover Ratio.  If Debtor’s Turnover Ratio is low then you can smell of something cooking . Sundry Debtors is field of balance sheet which indicated how much amount is due from customers and other parties(Receivables). We can describe Sundry Debtors as Udhari in hindi. Most of the fraud companies shows growth in PAT , because of increased in Sundry Debtors. It is quite easy to manipulate PAT by Sundry Debtors (Udhari) . These fraud companies increases Sundry Debtors amount each and every year but after few years write-off it .I don’t say Sundry Debtors is bad for every  company since some sector will have high Debtors' Turnover Ratio and some will have low . E.g . construction sector companies usually will have low Debtors' Turnover Ratio since they have to deal with government . Dues from government will be get delayed but will not be defaulted. Best way to compare company with peer in same sector.

You will see lot of companies are even trading below PE level of 3 , cash flow is positive and you start to believing this company is available very cheap . You will always wonder why this kolaveri  with this particular stock ? But, when you see Debtor’s Turnover Ratio is quite low , which indicate low quality of profit. You will easily come to conclusion why this kolaveri  is.

3.      Non existing cash :- This is the category where value investor should be more careful before investing . Company shows lot of cash in the balance sheet but in reality that does not exists. Satyam fraud is example of this.

Symptoms :- Very hard to determine if auditor is unaware or involved in the fraud . Large cap companies has to use few complicated trick for fraud and small cap companies  can even make fraud with some obvious tricks . Some of the example of this category is, cash in overseas bank a/c which is not known reputed bank . Bank in tax heaven country . If bank is India then it is non-schedule bank. Some times this type category company transfers cash (exist/non-exist) from company to subsidiary company at more than comfortable level price. e.g         T*n** Sol***** 

4.      Operator Driven Stock :- This type of category is dangerous when promoter is also involved in it .Many times stocks operators could have been involved for price manipulation even without knowledge of promoter .              Sometimes, good stock also get manipulated by stock operator.            

                         Symptoms :- Complete mismatch in stock valuation and fundamental .

5.      Money Laundering :- This type of companies are only use to convert black money to white money.

Symptoms :-  To be franked it is quite difficult for my level of person to distinguish real money generated by the company or by the money laundering.

Many of these so-called small & mid cap software/IT companies were known to be using the Hawala route in order to show income from software exports. Such companies do not even be having the requisite infrastructure or the requisite personnel required running a software company forget aside the any export orders. The next step is to set up a subsidiary abroad by renting a place or just even employing a person to conduct the operations. Most of the exports are done to duty free ports such as Hong Kong, Singapore or Dubai where the money can be remitted back. After that, the promoters conduct Hawala transactions by paying cash over here and getting dollars from abroad through the subsidiary. The same dollars transferred from abroad are shown as software exports in the company's books. In this way the company is able to report decent sales figures in its balance sheet by the way of export income.

The next step is to catch a flamboyant market operator through whom rumours about the company can be floated in the market. The share broker or the operator then spreads stories such as the company has got big software development orders or tie-ups and is going to report excellent profits. Naturally, the bogus export income drives up the net profit reflecting a healthy Earnings Per Share for the company. Since, the P/E of the company appears to be quite low in comparison with the industry standards; the stock appears to be an excellent buy.

The market operators start providing liquidity in the counter and consequently the volumes in the counter start rising. Many of the deals take place between two or three operators itself who start creating a demand for the stock. The stock price of the company is jacked up touching three to five upper circuits in succession. The promoters taking advantage of this situation start dumping their own stock to the small investors who in turn enter to buy. In the end we have the small investors who are left holding the stock which they have purchased at the high prices.

Money Laundering is very well explained at http://www.indiaforensic.com/software_laundering.htm  & http://www.indiaforensic.com/software_hawala.htm

I have discussed few types of fraud in Indian stock market context but fraud promoter are very smart and will invent new ways to loot investor.

Most of the retail investor who invest directly concentrate more on EPS & profit growth and do not pay required attention to quality of the profit . This is the way they fall in trap . Now , Rajiv Gandhi Equity Savings Scheme (RGESS), announced in the Union Budget will encourage more investor to invest in equity (probably directly) , same time fraud promoter will see more opportunity to trap retail investor. You might have heard that how much wealth one could have created if he had invested in Wipro in 1980’s (unluckily, I was not born) and Infosys 1994-95(I was not in stock market) . I just tried to show both side of the coin I do not want to spread negativity about stock market. I just want to educate retail investor with whatever little knowledge I do have. Above mentioned checks are just starting point for checking corporate governance level , there are many other factors which determine corporate governance level of the company.

I have provided list of the companies which are down more than 80% from their pick level of 3 year / 5 year high in bottom of this article. If one had done above mentioned checks 3-5 years back, then at least 80% stock in following list could have been failed for good investment candidate that time . So, One could have easily avoided big disaster investment mistake by checking corporate governance level. This list will also give chance to value investor to identify stocks which are down by just business reason and capable of turning around those business .  

Disclaimer :- This is the just list of companies which are down more than 80% from 3 year high as per best of my knowledge . I do not claim any of the company is fraud . It is up to investor to take call based on data submitted by company to stock exchanges .