How to detect and avoid fraud in the stock market

Over $9 billion was lost to fraud in 2022, and over $4 billion in scams have emerged so far this year! Here’s how to avoid these traps.

Fraud is apparently on the rise. Last year’s correction caused many once-loved growth stocks to fall by the wayside, while numerous financial scandals have recently come to light.

In 2022, the Federal Trade Commission reported a 44% increase in scam losses, reaching up to $9 billion.¹!

The cryptocurrency space is no stranger to scammers, and a lot of attention has been paid to stories about rug pulling, non-fungible tokens (NFTs), and of course the FTX collapse, a case that is currently being investigated. fighting in court. .

But the stock market is not immune to such dubious activities. While it is certainly more difficult to achieve, there have been numerous cases of scamming by even the most prominent companies.

Some of the biggest names that come to mind are Theranos (2016), Wirecard (2019), Luckin Coffee (2020), Nikola (2021), and of course one of the biggest in history, Enron (2001). ).

This is far from a complete list of deceptions by morally bankrupt organizations. And while the number of legitimate corporations far outweighs the scams, investors caught in that trap can end up losing a lot of wealth.

But is there a way to detect and avoid such tricks?

Identify financial shenanigans

Fraud detection is a complex process. And although all the accounts presented in the annual reports are audited by independent third parties, there is always the risk of false realities escaping. Fortunately, there is an easy way for retail investors to spot potentially worrying numbers.

It is called the relationship between securities and assets.

Accumulation/assets ratio = (∆ working capital – ∆ cash – ∆ depreciation) / ∆ total assets

Essentially, this metric is used to determine how efficiently a company can utilize its operating assets. However, it is also excellent for detecting subtle changes in accounting policy that could be an early indicator of fraud.

How to interpret the accumulation on assets

Generally speaking, the lower the number, the better. And a negative value can potentially highlight extremely efficient operations. However, this figure alone does not tell the investor much. Rather, it is the multi-year trend that reveals the real story.

A relatively stable value with a downward trend suggests that a company is becoming increasingly operationally efficient. Similarly, if this metric is trending upward, it indicates that operational efficiency is declining.

Where fraud comes into play is if the ratio of securities to assets suddenly skyrockets. Any sudden increase in this metric should be carefully investigated and traced back to its roots.

For example, let’s say a CEO’s compensation package is based on operating profitability. In that case, they may decide to reduce the rate of depreciation to make the business appear more profitable on paper than it really is.

A more sinister manipulation would be outright fraud. A company might report a sudden growth in accounts receivable and blame it on a temporary customer collections problem. In reality, this may just be the precursor to a false increase in sales growth in the following period.

Outperforming the average market return

Avoiding fraud is a crucial part of becoming a market-leading stock investor. And while the accrual-to-asset ratio is by no means the only screening tool out there, it is very effective at quickly detecting strange changes in accounting practices.

That’s why it’s one of hundreds of factors we carefully examine for our community. The Money Gear Bonus The service has already detected some questionable practices among Wall Street favorites. And by avoiding them, our investment research has helped generate spectacular returns.

In fact, since 2015, our stock insights have generated a staggering 798% return, which translates to an impressive 29.4% annualized return. Find out more here

Article sources

1. Federal Trade Commission, “All Lost Amount Fraud Reports”.