Markopolos spent the next 9 years writing memos and making presentations to the US SEC detailing the fraud being perpetrated by Madoff. He wrote these memos in 2000, 2001, 2005, 2007 and 2008. His 2005 memo was titled, \u201cThe World\u2019s Largest Hedge Fund is a Fraud\u201d<\/a>. Despite the provocative title, no one would listen. Madoff\u2019s Ponzi scheme kept growing larger and larger over this period. It finally collapsed in 2008 as a result of the global financial crisis and not because of the efforts of Markopolos. As clients lost money elsewhere, they started withdrawing their capital from the Madoff funds which had continued to report profits. The growing redemptions eventually led to the collapse of the Ponzi scheme.<\/p>\n The fall of Madoff shone the limelight on Markopolos who had spent almost a decade trying but failing to get the SEC to investigate Madoff and end the fraud. He wrote a best-selling memoir, \u2018No One Would Listen<\/a>\u2019, of his pursuit of the biggest financial criminal in history (the book is a must read). Markopolos was repeatedly asked about his \u201csecret sauce\u201d. How had an unknown quant been able to identify Madoff as a fraud while the SEC and investors with billions invested couldn\u2019t? In response, Markopolos wrote a short article on how anyone could spot a fraud (reproduced in full below[2]<\/a>).<\/p>\n We call this \u2018The Markopolos Method\u2019. The Markopolos Method to identify frauds is simple: assume fraud until genius is proven<\/strong>. Markopolos reckoned that a fraudster (be it an individual or a company) needs to lie and\/or exaggerate to attract attention. An investor\/company claiming to generate 10% returns with low risk is unlikely to find an audience, but one promising to double the money in 6 months is likely to attract significant eyeballs. People often fall in love with such fraudsters as they attribute the extraordinary but fake performance to the work of a genius. Bernie Madoff, Jeff Skilling (Enron), Elizabeth Holmes (Theranos) and Lance Armstrong are examples of people whose genius was entirely based on fraud.<\/p>\n Markopolos doesn\u2019t suggest that every extraordinary performance is fraudulent. For example, Apple reports unheard of profitability in the smartphone industry where every other player struggles. However, the evidence of its success is clearly visible when people line up to pay 1000 $s+ for a new iPhone while other companies struggle to sell their products at half the price. As per Markopolos, extraordinary performance should be supported by extraordinary evidence. It is a cause for concern only when the evidence is lacking.<\/p>\n Whenever companies report extraordinary performance, the first step for an investor should be to dig deeper to understand the source of the performance. The market often trusts such extraordinary performance to be driven by some special capabilities (often articulated by the management) without any independent verification. A higher degree of scepticism will minimize the likelihood of us falling victim to frauds masquerading as genius. We discuss below a few case studies of companies from the Indian market that were reporting exceptional performance but had some serious red flags. Note: Names and Financials have been changed intentionally.<\/p>\n <\/p>\n Case Study 1:<\/u><\/strong> B2B textile company (\u201cTexCo\u201d) reporting extraordinarily high profitability<\/p>\n TexCo was a B2B textile company supplying to the likes of WalMart, Jockey and Toys \u2018R\u2019 Us with 30%+ EBITDA margins and 70%+ pre-tax ROCE. TexCo\u2019s profitability was even higher than that of B2C apparel companies like Page Industries which have strong brands and pricing power. TexCo\u2019s reported financials suggested that it might be one of the world\u2019s most efficient and profitable textile companies.<\/p>\n However, a deep dive into the audited financial statements and annual reports threw up multiple red flags related to revenue recognition, cash\/forex position and unlisted\/undisclosed related parties. While TexCo had claimed that it would continue to grow rapidly while maintaining margins, subsequent performance has been disappointing with margins shrinking and balance sheet deteriorating. As a result, the stock has fallen ~85% from its peak.<\/p>\n <\/p>\n Case Study 2:<\/u><\/strong> Mid-sized jewellery company (\u201cJewelCo\u201d) reporting high revenue and profit growth<\/p>\n In a difficult business environment for the jewellery industry, JewelCo was growing faster than Titan with better margins. This despite having a substantially weaker brand in the organized jewellery space. The stock went up 14x in a 4-year period as investors bought into the \u201cnext-Titan\u201d pitch.<\/p>\n In the euphoria of JewelCo\u2019s stock appreciation, the red flags were ignored. JewelCo was reporting a 4x employee productivity vs Titan in the retail segment which is \u201ctoo good to be true\u201d given the similar business models of both the companies. JewelCo was also reporting high ROCE (>30%) in the commodity B2B jewellery exports segment. This business had a 9-month receivable cycle and a large chunk of these receivables has now been written off or are stuck. The stock is down ~95% from its peak and the debt has been downgraded to \u2018Default\u2019.<\/p>\n <\/p>\n Case Study 3:<\/u><\/strong> India\u2019s fastest growing beverage company (\u201cBevCo\u201d)<\/p>\n BevCo was rapidly gaining market share despite competition from incumbents like Coca-Cola, Pepsi and Parle Agro. BevCo\u2019s edge was believed to be its Tier-2\/Tier-3 focus and low price-points. Over FY12-FY16, BevCo reported a Revenue and PAT CAGR of more than 60%. Exceptional financial performance led to the stock going up 3x from its IPO price. BevCo stock was actively marketed as India\u2019s only listed beverage company.<\/p>\n While BevCo claimed to have a high and rising market share, there was little on-ground evidence of its sales. BevCo\u2019s products couldn\u2019t be found in retail shelves and very few consumers had heard of the company let alone consume its products. None of the independent market research companies like Nielsen and Euromonitor attributed any significant market share to BevCo. This was a company that only existed in the stock market. BevCo\u2019s stock price eventually collapsed as the full extent of its financial shenanigans were revealed in 2018\/2019.<\/p>\n All the above companies and their managements were once labelled as \u201cdisruptive\u201d and \u201cvisionary\u201d. The Markopolos Method would have required us to study these companies in more detail to understand their \u201cgenius\u201d. That deep dive might have helped us identify the red flags and possibly avoid them.<\/p>\n <\/p>\n [1]The Mad Who Figured Out Madoff\u2019s Scheme, CBS News, https:\/\/www.cbsnews.com\/news\/the-man-who-figured-out-madoffs-scheme-27-02-2009\/<\/a><\/span><\/p>\n [2]Harry Markopolos: How to Spot a Fraud, Bloomberg Businessweek, https:\/\/www.bloomberg.com\/news\/articles\/2011-09-22\/harry-markopolos-how-to-spot-a-fraud<\/a><\/span><\/p>\n![\"Q3\"](\"https:\/\/2point2capital.com\/blog\/wp-content\/uploads\/2020\/01\/Q3.png\")
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