Explainer: Plato’s Red Flags Process

The Red Flags process is a unique and powerful part of Plato Investment Management’s investment process.

The genesis of the process was almost 10 years ago – I was working in London and I was running two large long short funds. And I happened to be invested in a company called Let’s Gowex, a Spanish tech company that were involved in the public Wi-Fi space. They were being hailed by the Spanish Prime Minister as the shining light that all Spanish companies should look for. Their market value had increased in value by about 40 times, they were valued at almost €2 billion. Sure enough a couple weeks later a US short seller identified that they overstated revenue to the tune of about 10 fold and the price, as you can imagine, went into freefall, fell 60% almost immediately. A week later the company was insolvent and the CEO was being indicted for fraud.

That’s obviously not exactly what you want as a company you’re invested in, but as they say, there’s nothing wrong with making mistakes, you don’t want to make the same mistake twice and you learn so much more from your failures than you do from your successes. And this was certainly the case here.

We did something of a post-mortem on the company and said if we looked a little bit harder, perhaps looked somewhere else altogether, could we or perhaps should we have been aware that not everything was as it should be with Let’s Gowex.

Checking the molehills for mountains

And sure enough there are a couple of things that were not right. Firstly they used an auditor that virtually no one else in the entire world was using, so red flag number one. The second red flag is they were using, they were paying that auditor a tiny amount, it amounted to about 0.04% of revenue. A typical company in that space you’d expect to pay about a percent of their revenue in auditing remuneration. So those two things if we’d been, looked a bit more carefully we probably, probably would have given us pause.

So what we did at that stage is sort of led us on a bit of a process of discovery where we analysed across 10 different countries, going back about 10 years, all instances where companies had very unusual auditors, Bernie Madoff was one of those. Or they were paying their auditor extremely small amounts or even extremely large amounts. And sure enough in those cases on average you want to tread very carefully and be very cautious around those sorts of companies.

We then did an analysis of every corporate scandal, corporate failure we could get our hands on and slowly but surely, we built up that list of red flags, to the extent that today at Plato there is 126 of these red flags. And they span forensic accounting – if you ever having trouble sleeping at night, I can highly recommend the forensic accounting literature, it’ll put you straight out – we will look at signs of financial distress, we’ll look at remuneration structures, ownership structures, we’ll look at also governance, social and environmental factors.

It all adds up

We you consider just one or two red flags, they are not particularly strong indicators of a company’s weakness. But when you add together numerous red flags a situation arises where the whole is much, much greater than the sum of the parts.

The magic number seems to be six red flags. If a company has six or more red flags then it almost invariably tells us two things – one this is likely to be a land mine on the long side of our portfolio and secondly this is a very fertile area to look for shorts, companies that are going to underperform and potentially go to zero.

So it’s definitely a unique part of our investment process and before we make any investment every single company needs to pass through those 126 red flags that we look at.