Short seller Carson Block makes his living by spotting frauds.
He made his name shorting Chinese company Sino-Forest and tries to shine a light on companies that are total fakes and those that are stretching the truth.
In a conversation with Business Insider, Block said he is seeing less of the out-and-out frauds that led to a total collapse of a company, but there is a new trend that worries him.
“There are fewer and fewer abject frauds from places like China,” Block told Business Insider.
“There has been a shift in accounting, though — more and more companies are using financial engineering to make things on their balance sheets look very different than they are,” Block said.
He mentioned, as we have before, that the gap between adjusted earnings and nonadjusted earnings is the largest it has ever been, and corporate buybacks are at their highest level ever as well.
This sort of “financial engineering,” in Block’s opinion, lets companies get away with more than they would otherwise. And while there is nothing criminal occurring, many firms are coming up to the edge.
“It’s kind of like the financial crisis in the sense that these companies aren’t doing anything technically illegal but they’re coming right up to the line,” Block told us. “It’s hard to find people to prosecute because they’re not getting quite high enough for it to be fraud.”
Essentially, Block is saying that these companies may not be doing anything legally wrong, but the engineering is distorting their true value in the market. The difference in adjusted and unadjusted earnings has been a source of debate for some time.
On the one hand, companies say that writing off one-time losses gives a better picture of the underlying business. On the other hand, critics argue that ignoring the negative parts of the business is simply cooking the books to look better for investors.
Block is clearly in the latter camp, and said that finding the companies who consistently stretch their earnings is a good starting point for a short investigation.
Additionally, practices like buybacks have hit record numbers, allowing companies to hit analyst expectations for earnings. Some analysts feel this is “financial engineering,” to use Block’s term, while others feel it’s a legitimate use of capital to reward shareholders.
So while massive frauds on the level of Sino-Forest may not be as prevalent as they were when he started six years ago, Block thinks that the breadth of the truth stretching is increasing and becoming more of a worry.
“It might not be illegal, but it is a major problem and we’re seeing it happen more and more,” Block said.