At Bellwood, we follow a quantitative process that ignores popular narratives and makes decisions based on underlying fundamentals like profitability, financial strength and valuation. One of the things that differentiates us from other quants-oriented asset managers is that we subject our portfolios to a more qualitative ‘red flags analysis’ before implementation. So the numbers always tell us why we should buy something. We never buy something for qualitative reasons where the numbers don’t stack up. But while we never buy something that the numbers don’t support, we will at times not buy something that the numbers say we should because of qualitative red flags. For us, the biggest red flags are serious questions around a company’s accounting practices, from credible sources.
We saw a very clear example of this play out in the last quarter. We’ve had Wirecard AG (a German internet payments company) on our watchlist for some time, based purely on the numbers. In May it came onto our shortlist and we discussed Wirecard’s merits: It was profitable, had high growth, a decent valuation, strong cash flows and modest debt – the numbers looked good. So we decided to put it through our red flags analysis. Even a cursory glance through their news history reveals that there have been serious questions around their accounting practices, from credible sources, for some time. As a result, we didn’t invest – an easy decision.
In June, Wirecard announced a $2 billion hole in their accounts. The stock price has since fallen 98%. This type of qualitative red flags analysis is simple and we believe it adds significant value to our process. It’s by no means a guaranteed system, but it does a good job of managing the risk associated with fraud, among other things.
To be clear, we didn’t predict the Wirecard fraud, nor did we know that it would play out so quickly after our discussion. But we did see the potential and we avoided it. There are other examples where there is good reason to be suspicious of a company’s accounting where so far nothing has happened. A good example would be Alibaba. Alibaba has been under a cloud of suspicion since its listing in 2014, though it is making new highs as we speak.
We recognized the ‘numbers’ return potential for Alibaba in 2016, but decided not to invest because of their accounting practices. We would make the same decision today. Time will tell if there is substance to these allegations or not. It’s worth noting that between 2009 and 2018, Wirecard’s share price had increased 50x – but now the price is lower than in 2009.
We sleep easier knowing that the companies we hold aren’t under a cloud of fraud suspicion that might implode at any time. We trust that our clients do too.