Three Investor Lessons from the Satyam Scandal

The Satyam (SAY) scandal has provided a stark reminder to many about the dangers of investing. There are, however, diverging trains of thought on what to take away from this. One school says that this goes to show that the rest of the world is not that much unlike America and that an Enron or Madoff scandal can happen anywhere. Underlying this belief seems to be the idea that these sorts of scandals are somewhat random and unpredictable.

A second school of thought says this exposes the dangers of investing abroad and particularly in emerging markets where business culture, auditing standards, accounting rules, regulatory structures, and social customs can differ markedly from the United States. The thought here is that the developing world might not have quite as strong checks to insure accuracy of data reported by businesses and that American investors will inevitably experience a lack of awareness of many issues in any particular nation that might differ from the US.

For my money, I am in the latter school of thought. This is not to suggest that one should completely shy away from investing in the rest of the world and the emerging markets; rather, one needs to be aware of the different risks involved by investing in the international sphere.

There are several reasons why I do not view this scandal as simply India’s version of Enron. Certainly, this event has rocked the Indian markets in the same sense that Enron did the American markets, but that does not mean the scandals are necessarily similar in nature and that this could happen in the United States any time. The nature of the fraud involved is key to me. If one were to examine the fraud cases in the United States, a lot of them involve complex schemes and companies taking advantage of auditors’ lack of knowledge about difficult-to-price assets. While auditors might work in particular industries more than others, they still do not have the expert knowledge of asset classes that one who works in an industry every day might have.

Look at a company like Intel (INTC), for instance, that produces high-tech devices that rapidly depreciate in value. From an auditor’s perspective, it might be difficult to tell the difference between a new chip with high-value and an obsolete chip with virtually no value. These types of situations can create opportunities for fraudsters.

While a lot of facts from the Satyam scandal are still missing and I imagine we will learn more over the coming weeks and months, the one particularly frightening thing about this is the seeming ease with which this fraud was committed. This does not appear to be a case of complicated and difficult-to-value assets vexing auditors. Satyam had a cash balance over $1 Billion and 94% of it was fictitious! Surely, one would think, that auditors should have noticed such a large amount of cash that did not seem to exist. Cash is a much more difficult asset to “fake” or create an illusion of heightened value on than microprocessors, oil supplies, or mortgage-backed securities. How could a massive store of missing cash escape the attention of auditors?

If a company could fake this much cash on its balance sheet without auditors even batting an eyelash, could this mean that any company in India is potentially vulnerable? It’s worthwhile to note that as a publicly-traded company traded on an American exchange, Satyam was subject to US Generally Accepted Accounting Principles (GAAP) and Sarbanes-Oxley. Yet, even this did not protect investors. But why?

There’s a whole host of possible reasons and it’s difficult to say what the truth behind the matter is without all the fact. Some possibilities:

(1) Satyam was audited by Price Waterhouse of Hyderabad, India, which is connected to PricewaterhouseCoopers. It’s not clear to me what sort of people would be brought in to do this audit, however. Obviously, you would need people familiar with US GAAP. Was the auditing staff largely based out of India? Or did PwC bring “experts” over from the United States?

There is potential for problems with either option you choose. Would Indian-educated accountants necessarily be familiar with US GAAP and GAAS on more than a shallow level? Keep in mind, these auditors could possibly only use these standards once per year while auditing Satyam. Perhaps an audit, while theoretically falling under American standards, is carried out more closely to Indian standards in actuality.

If Americans were brought in to examine Satyam, would they necessarily have more than a shallow understanding of Indian business practices, regulations, and cultural customs? Would the Americans be “taking the word” of people at Satyam due to their own lack of expertise?

(2) Another possibility is something about Indian business practices and the regulatory environment make it easy to conceal this type of thing from the view of auditors. As a foreigner, one is simply left guessing about conditions in a particular country. An American operates with a lot of assumptions that are mainly based on their own experiences in America; those assumptions may be completely invalid when carried over to a nation halfway across the globe.

(3) Its also possible that auditors or financial institutions were acting in collusion with Satyam. Thus far, there is no evidence of this, but it can’t be ruled out yet. Ironically, this would probably be the least damning of the options because it would suggest that there was a lack of effective checks involved here and this might be remediable. Though, it still might expose the ease with which such collusion could occur overseas.

These are just a few possibilities. I am sure there are many others and it all cuts into the harsh reality of investing: we are all making decisions based on limited information. The best we can do is maintain awareness of this and seek out investing strategies that minimize the effects of this. With that, I offer these thoughts on investing:

(1) When Investing in Emerging Markets, Be Aware of Heightened Risks from Greater Uncertainty

Personally, I have never analyzed any companies in India and do not have that much knowledge of the Indian market. However, I do examine a number of companies from China. One thing I’ve found is that the financial statements are not necessarily as illuminating as they might be for American companies, even when they are prepared in accordance with US GAAP. This goes back to a previous thought: accountants in foreign nations may not necessarily have that great of an understanding of American standards, culture, and laws. While this is true in an auditing capacity, it’s also true in an in-house capacity. A company may hire accountants who have limited understanding of American standards and culture.

On that note, one thing I’ve personally noticed from examining Chinese solar companies is that the financial statements for some of the companies are extremely difficult to understand and gather important information from. I found myself particularly vexed reading through Yingli Solar’s (YGE) 20-F filing. Due to this, I have shied away from Yingli personally. This does not mean that Yingli is a bad investment --- merely that I made a conscious decision based on a general feeling I got from reading the financial statements that the company might not have totally understood American investors. If this was the case, it was also possible the company did not fully understand American accounting standards. Based on this, I assigned a higher level of risk to Yingli.

I don’t mean to single out Yingli, as it may indeed be a great investment and I have encountered some very smart investors who think highly of the firm, but my thought was that if I was having particular difficulty understanding their disclosures, maybe I should steer clear rather than *assume* that everything was alright.

(2) Different Countries, Different Rules, Different Cultures, Different Education

Every country has its own set of laws and customs. However, most of us are not lawyers. Instead, we gain our understanding of the law through observation. We have a sense that something is not legal. We have a sense of what is acceptable and what is not. Those standards do not necessarily carry over to every nation. This might seem somewhat obvious in a way. What might be less obvious is that people born in another nation might have a completely different way of learning and a completely different education.

This becomes especially important when we are talking about accounting and auditing. Are Russian accountants necessarily well-schooled in American accounting standards? I have no clue how one becomes an accountant in Russia, but I imagine they have their own procedures and their own system of education and that it differs in many respects from the system here in America. If a company in Russia is traded on an American exchange, how does it find the accountants who are to do the American reporting? Are Russian accountants simply given a two-week crash course? Is an American brought over to teach others? Are Americans running the whole operation? As mentioned earlier, no matter which way you look at it, there are a potential host of problems.

The main takeaway here is to simply be aware that other nations operate differently and even abiding by American standards does not necessarily mean that all differences immediately disappear.

(3) Diversify, Diversify, Diversify!

The most important takeaway here is that investing involves a lot of uncertainty. No matter how skilled or knowledgeable you are in finance, accounting, business, or the particularly industry you are looking at, there is always something out there that you did not know about and that you will not anticipate. The best way to deal with this uncertainty is to mitigate the risks by diversifying your portfolio. This is true even if you are investing only in American companies, but I think it’s even more true when investing in emerging markets.

A few parting notes: while I would not necessarily discourage anyone from investing in emerging markets, I will suggest that it might be prudent to have a great deal of reluctance towards investing in India for the near-future. Until we know how the Satyam fraud went undetected by auditors for so many years and until we see some evidence that this is not happening all over India, I would veer away. Naturally, anyone is free to disagree with my assessment.

Finally, a lot of what I have offered here is speculation about what might be happening in overseas companies and auditing firms. If anything is not factual, feel free to inform me. My bigger point here is that sometimes, we don’t know all the facts. All the same, we should seek as many of those facts as we can get.

Disclosures: No position in SAY or any Indian/emerging market ETFs