Watching for fraud red flags can seriously boost portfolio returns

Corporate fraud is widespread, even if we only notice it when it blows up, leading to firings, arrests, or lawsuits.

In fact, fraud costs 3 per cent of enterprise value — and thus stock returns — every year for the average U.S.-listed company, according to recent academic estimates.

A new report from GMI Ratings shows that investors can significantly boost returns simply by looking out for certain red flags.

When GMI eliminated the 25% of companies in the Russel 3000 index that scored the lowest on its fraud detection metrics, portfolio returns rose from 7.6% to 9.8% over a 10 year period, a 29% boost.

Here’s their chart of the difference between the regular index and one with the worst-rated companies subtracted:

These are a few of the red flags that GMI looks for:

  • Compensation incentives for CEOs and CFOs that are very high relative to base salary
  • Late or frequently amended filings
  • Consecutive uninterrupted growth in earnings per share
  • Accounts receivable are growing at a different rate of sales
  • Low asset turnover, and excessively large intangibles

Read the full report at GMI Ratings.

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