THE BLOG
01/17/2013 03:21 pm ET Updated Mar 19, 2013

Steroids, Stocks and Too Good to Be True

What can investors learn from the sagas of Lance Armstrong or Roger Clemens? Are there lessons from observing the spectacular career heights and precipitous declines of some of our most celebrated athletes? We exalt in the extraordinary because it makes us feel closer, as humans, to grandiosity ourselves. However, phenomenal success over a long period of time is sometimes the result of some unnatural help whether it's steroids, inside information, or accounting fraud. We need to consider when results, whether for cyclists, pitchers, runners, fund managers, or public companies are perhaps too good to be true and how we might look for the signs.

You're probably familiar with the Apple iPhone voice recognition application "Siri." This software is built into the newest versions of iPhones, to facilitate the "search" function, generally as well as by typing in the words. The phone doesn't "understand" you, but a speech recognition program translates your query so that the search is performed using word recognition. The company that provides this tool is called Nuance and it purchased the speech recognition technology from Lernout & Hauspie, a bankrupt Belgian firm, for $39.5 million in 2001. The story behind L&H is an example of "too good to be true."

Lernout & Hauspie was a high-flying stock in the late 1990's, very appealing to investors on many levels. Management visited the offices of my former employer several times, and demonstrated, with great fanfare, how a laptop would type, without error, the words that an L&H executive was speaking. Not only was their technology magical and sexy, but their director of investor relations was a six-foot tall blonde knockout who dressed like Catwoman. Everyone from the Belgium royalty to the top fund managers in the United States wanted to know the L&H executives and own their stock, which climbed to a monstrous valuation of $10 billion in early 2000. Even Bill Gates had Microsoft buy 7 percent of the company. The idea was that software enabling computers to recognize speech would revolutionize the way we all worked.

The problem was that this was all too good to be true. While the software was indeed groundbreaking, the underlying company was riddled with faults. The demonstrations were rigged to some extent. Speech recognition software improves the more it hears the same words from the same speaker, so the results were better than with a new user. More importantly, the management was fabricating some financials such as sales of over $125 million in South Korea. The auditors, KPMG, found no money there although the company had pledged the revenues for loans which the executives promptly put in their pockets and the $100 million "vanished." No one likes a headline such as "Lernout Unit Engaged in Massive Fraud to Fool Auditors..." which the Wall Street Journal ran on April, 6, 2001. From a high of $52 per share in December of 1999, the stock sank to under $2 in November of 2000.

Were there signs? Sure, lots of them. However, when we are dazzled and seduced, as fans or investors, we don't pay attention; we look for re-enforcement of our exuberance. How could it really be possible that L&H could sell $127 million of product, an amount over 50 percent of the entire worldwide revenues, to South Korean clients, in a year when they hadn't sold $1 million in the country the prior year? Were all the short sellers, many of whom had studied L&H's filings carefully with the SEC and noted discrepancies, all wrong? The founders and CEO, Gaston Bastiaens were eventually found guilty of accounting fraud and misuse of funds and sentenced to 3-5 years in Belgian prison.

L&H certainly isn't the only one that had us fooled. Bernie Madoff reported constant, positive returns for over thirty years, through market peaks and valleys, and very few, if any, of his investors questioned the results, perfectly content with too much of a good thing. The SEC, seemingly emboldened since the markets emerged from near obliteration in 2008, has carefully circled hedge fund managers such as Raj Rajaratnam of the Galleon Fund whose returns were just too good to be true, tightening the rope slowly and meticulously. Rajaratnam is now serving an eleven-year jail sentence for insider trading and other securities violations.

Cynically speaking, if you can time things right, you can profit from indiscretions or underlying illegal activities, by owning the stock during the climb and selling before the fall. Certainly philanthropist, Carl Shapiro, endowed many non-profit institutions in Boston from the Museum of Fine Arts to several Harvard related hospitals, with funds enhanced through his portfolio appreciation with Bernie Madoff. But, be very clear that this is a risky strategy, because if problems emerge and the roof caves in, you might still be inside the house.

Is there a strategy for avoiding jumping into an investment soon before its collapse? Assuming that most of us prefer our investments to remain above the law, our sports stars following the rules, and our own consciences clear, we need to do the following:

• Be skeptical yourself of any incredible story. Do your homework first. There is an abundance of information available on all public companies and on investment managers which is required by the SEC. Look there first.
• Ask questions if you don't understand. Ask the person who told you about the idea. If the answer is not adequate, and you are still unclear about the hot streak and its future continuance, this might be sign that you should stay away.
• Read what skeptics who might be tracking the stock, fund, or investment have to say. Online sources are a great resource for this. Then, think about how likely it is that these exceptional results are truly sustainable.

If, after taking these steps, you can't comfortably endorse the investment, you've probably discovered something that may be too good to be true. While you might feel left out on the way up, you'll be very pleased with yourself for doing your research and remaining level-headed, all the way down.