The Business of Fraud

Inteligex • November 23, 2022

Wouldn't it be great if when you looked at an investment it had a sign on it telling you if it was a 'fraud' or a 'scam'.  You wouldn't waste your time on it and you'd move along to the next thing.  The problem is that those signs don't exist and successful frauds by definition look very compelling to lots of investors.


There have been a lot of business frauds over the years: Enron, Bernie Madoff, Worldcom, Tyco, Theranos etc. and now FTX Crypto.  The pattern is unfortunately familiar: the promise of big returns means lots of people put their money in, it turns out to be a fraud and they lose it. 


A business fraud can happen at any time but they tend to follow financial cycles. Think of the time we are in at the moment. We've just come off the longest running bull market in history, most money invested had a positive return i.e. it made more money. So paper profits increased and investors felt richer. When they feel richer they want to reinvest the money that they've made to make even more money, so there is more money in the system to invest. Because frauds typically need more capital to continue they need more investment so are easier to maintain in a bull market.  But they get exposed in a bear market. As Warren Buffett famously said "Only when the tide goes out do you learn who has been swimming naked". Well, the tide is receding now as the long bull run is over so don't be surprised if bare bodies start to appear.


But how do you spot a fraud in advance and the confidence tricksters and con artists who run them?


Most of us think we would be able to spot a fraudulent business or investment but the data suggests that is not the case.  Those that perpetrate the fraud, the con artists, are incredibly convincing and unfortunately many of us succumb to their message of making money because we just want it to be true.  Hey, who doesn't like the thought of easy money and when there is a flourishing bull market many people's disbelief is suspended!


And it's not just that they are convincing, they also have the ability to assemble a following of advocates and evangelists (and sometimes sycophants) who genuinely believe the message they've been given (they've drunk the cool aid so to speak).  This means that what starts out as a small following turns via a network effect into an army of positive supportive soldiers.  Combined with the classic con artist sales tactics of projecting great returns and preying on your FOMO (Fear of Missing Out) act now! exclusive club! etc. you have one compelling sales pitch.  The more times you see the pitch and the more personal references you have of 'somebody who knows somebody' made this amazing return then the more you are likely to consider it a viable investment.  But that may not be the case! 


In order to help you spot a fraud ask yourself some questions:


  • Do you understand the proposition?  If you do then you can make an assessment of its viability and you are going in with your eyes open.  If you don't then how will you expect to know if the wool is being pulled over your eyes!
  • Is there evidence of the forecast returns?  Can you see documented, 3rd party verified evidence that the possible return on investment has been achieved by other investors or is it just spin and sales speak.
  • How speculative is it?  Everything basically comes down to probabilities so how probable is it that the circumstances required to get these great returns will be met or will continue to be met going forward.
  • Are you being told to tie up your money up for the long term?  We're all used to long term investing but look out for roadblocks to withdrawing your investment.  This is a classic ploy of fraudsters, they need a continual stream of new money so that they can pay those entitled to withdraw (the classic ponzi scheme).


Don't be put off by the positive comments of others or the spin coming from the company.  Do your own research and trust your judgement.  Of course, it can be difficult when very large supposedly smart people at investment funds are saying it's the real deal.  BUT remember, they often have a conflict of interest as an increased investment demand drives up valuations leading to higher returns for them.


In a downturn you also discover those business models that just don't work. In the heady bull cycle they may have been the darlings of investors as the sales kept growing as did the company valuations. But when capital gets more expensive there is more analysis and questioning of the key business metrics. Is the business model profitable? What is the underlying profit per customer? What is the cost of acquisition per customer? What market growth potential still exists?  There are a number of businesses that fall into this category and their stock prices have been hammered recently.  Think food delivery, online used car sales, buy now pay later and ride hailing to name but a few.


If it looks too good to be true, it usually is.



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