Sandy Winick’s $140 Million Penny Stock Fraud
Earlier this week news broke that Sandy Winick committed unregistered trading and securities fraud. The businesses involved were Resource Group International, a Wyoming corporation based in Thailand that says it developed a revolutionary fertilizer, and RainEarth Inc., a Nevada corporation based in Beijing that says it is in the mineral-exploration business and developing a specialized fibre. The ring on 9 people (4 from Canada and 5 from the United States) sold investments through a fake investment bank Denver Gardner Inc. to international investors via telephone.
Every few years a large story breaks on investment fraud, and with this latest release I want to share some techniques I use to protect my portfolio from fraud. Most of the time fraud will be difficult to discover for individual investors so the most important way to protect yourself from fraud is to make sure you have a diversified portfolio and be very skeptical of companies that are performing seemingly to good to be true.
Detecting Fraud
Penny stocks are one area of investing that is highly susceptible to fraud. There are various ways to manipulate penny stocks due to their low market cap and lack of reporting standards. As an investor in penny stocks it’s important to be aware of these risks and learn how to identify suspicious companies that could be fraudulent.
Over the past few months I have been pushing that investors should know exactly what they are investing in. I have given many tips on how to value companies, how to find penny stocks to buy, and diversifying your portfolio. Today, I am going to examine how each of these articles can help you identify and protect yourself from fraud.
Value Investing Approach to Identifying Fraud
Value investing is an approach used by investors to measure a companies intrinsic value. Using various methods investors look at a business from the inside out. A value investor seeks to find the core business models and identify how they will effect companies profits and share price moving forward.
A value investor does not use market hype, technical indicators or speculation to make an investment. These three methods can lead investors very susceptible to fraud because they have not analyzed the business only its signals. One way to identify potentially fraudulent businesses is to take a value investors approach when analyzing a company. Read this article to learn how to value a business and determine if it is a suitable investment.
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Diversifying Your Portfolio
No matter how much research you do there is always a possibility you can be a victim of fraud. History has shown us a few distinct examples of fraud that were executed so well that millions of investors had become victims. Companies such as Enron, Worldcom, Crazy Eddies, Bernard Madoff and the most recent scandal by Sandy Winick (Resource Group International and RainEarth Inc.).
Even the most prominent figures on wall street had fallen for the schemes mentioned above. The men who pulled of these scandals were experts and extremely savvy at manipulating financial statements. Sometimes, a scheme can be so well masked that it is extremely difficult (if not impossible) for the individual investor to detect. In these instances Diversity is your most powerful weapon to fight fraud and protect your portfolio.
While working as a valuation analyst I saw first hand the dangers of not having a diversified portfolio. During this span Bernard Madoff was found guilty of running a ponzi scheme. I had 3 clients that had invested nearly their entire portfolios in Bernard Madoff Securties, LLC. Some of these accounts numbered in the millions of dollars and it was an extreme eye opener for me. These people were victims and because they did not diversify their portfolio they lost everything they had worked so hard for. Making sure you have a diversified portfolio is probably the most important piece of advice I can give investors to protect themselves from fraud.
How Do Companies Fraud So Many People
When in college I went to a presentation by Sam Antar the CFO of Crazy Eddies. During the coarse of his presentation he discussed how they manipulated financial statements, Fooled Investigators and created one of the largest cases of fraud in the U.S. During this presentation I learned a great deal on how even companies that look squeaky clean can be fraudulent.
Crazy Eddies was an electronics retail giant in the 1980′s. Seemingly out of no where the company was able to turn massive profits and become large enough to go public. During the presentation Sam told us how they were able to make it look like Crazy Eddies was much bigger than it actually was.
Basically, their fraud was a simple trick that enabled them to make their company look like it was worth much more than it actually was. When the company was going public they had to fool auditors into thinking they had much more inventory then they actually did. To do this they would use women to distract auditors when counting inventory. Sam told us they would have their electronics stored in a warehouse and would pile up a few rows of inventory to make the warehouse seem full. When the auditor started to count the inventory they would send in an attractive female to flirt with the auditors and distract them so they would not see that the warehouse was actually mostly empty. This trick is basically like wrapping a hundred dollar bill around 50 1 dollar bills to make it look like you have more money.
This was an extremely important lesson for me to learn as an aspiring investor. If you are using the value approach to investing you would not have uncovered this type of fraud in your research and would have been a victim. Similarly, the Madoff fraud was very hard to detect by investors. The lesson here was the steady profits. Madoff was able to return to his investors a steady profit margin no matter what the market conditions were. Keeping a look out for this type of stuff is important. If you see something that is too good to be true it probably is.
A Lesson from Penny Stock Fraud
The biggest lesson here is diversity. By diversifying your portfolio and not over investing in any one asset you will guarantee that your portfolio will survive if you become a victim or fraud. Always, be skeptical of companies that seem to good to be true. While looking at finances are their patterns in the numbers (growth, margin or costs) that seem out of place? In cases like Crazy Eddies it would have been hard to tell from just looking at numbers because the inventory was miscounted. In these instances carefully consider the benefits vs risk.
For penny stock investors the potential for fraud is even greater with lack of reporting standards. As a personal rule of thumb I like to stay away from companies that do not have readily available financial statements. I mentioned several times that you want to know what your investing in. If you don’t understand how a company makes money it’s a good idea to skip that investment opportunity. Know what you are investing in to protect your portfolio and yourself from becoming a victim of fraud.
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