I hate calling things bubbles, but I think we're in a period of extreme euphoria where you read and speak to investors and they say that the numbers don't matter and the financial statements no longer matter because this is changing the world. I say, well, I've seen this before.

You know, I saw that Nortell was changing the world and Lucent and Cisco and 360 networks. They were building out the infrastructure of the internet that we're using today. But those companies don't exist anymore.

Anthony Scilipoti is a forensic accountant who saw what others missed, predicting the collapse of both Valiant Pharmaceuticals and Nortell long before it happened. He spent decades reading what companies don't want you to see, the footnotes. Now he's spotting familiar warning signs in today's AI boom.

I was an accountant and I was working at Arthur Anderson doing the normal audit sort of preparatory work and I found it unfulfilling because the work I would do I would find interesting or concerns with the accounting or otherwise and the clients it didn't end up ending anywhere. So, what ended up happening was there was some due diligence work to do where we could actually look at transactions, companies calling us to say, you know, we want to spin out this business or we want to make this acquisition. And then I asked, put my hand up, said, listen, can I do that sort of work? And then I started doing it and I loved it. I saw some huge fulfillment.

And then it's all about people you meet. I met a gentleman named Al Rosen and he was head of accounting at York University and he was a forensic accountant. He had his own practice. He taught us to pass the exam or the CPA exam at the time and I said you know I'd like to work with you and he said well you get your CA work done and then we'll think about it. And that's what I did. And so then I toutelaged under him for some four years. And that really made it happen.

I was not on the Enron file. I left Arthur Anderson in 1997. Couldn't even spell Enron at the time. And it's a very sad thing what happened.

They essentially had a number of offbalance sheet exposures. So they would enter into derivative type contracts where that were tied to an energy price for example or even the company's own stock price and it'd be like this debt only comes due if the stock price falls to X. This debt only comes due or this derivative transaction we'd entered into and Ron was an energy trader. so if the price of electricity in kilowatt hours rises to a certain amount well then there this debt is no longer due. If it falls to this level then they're they have to pay some counterparty.

And so those were those those risks were essentially offbalance sheet. So those were not sitting on the company's liabilities. They were all contingent and at the time the accounting rules were such that the this these numbers were not included on the liabilities. They were just in the notes. And so all of a sudden so people weren't paying attention because nobody read that reads the notes. And so then all of a sudden things started to happen. There was a change and movement in commodity prices. Okay, this is now we're dealing with the dot. There was a lot of a lot of changes that happened in the economy. We we had a we had a a uh a recession in the early 2000s, right? And so that led to a lot of movements in commodity prices that triggered the derivatives. Surprise, surprise, they can't make the payments. It's done.

well, if it wasn't on the balance sheet, then investors and wouldn't wouldn't have noticed that that there was not enough assets per perhaps to cover. and and why the implication to Arthur Anderson which I think is important and then it's near and dear to my heart is you know the auditors at Arthur Anderson they're working on the file they ended up signing off on all these things well when essentially the proverbial hit the fan all of a sudden they were asking questions and the regulator asked for the working papers of the auditor that the papers of which they would support the audit work and they knew perhaps that they didn't do enough work so they shredded the documents. So all of a sudden they became guilty because of their actions

and so it was found in the courts um upon appeal that uh Arthur Anderson was not guilty but that was way after the fact because Arthur Anderson was already was brought to its knees and it was over. became a scapegoat for everything wrong with uh with with accounting at the time and uh look change needed to happen. Arthur Anderson was around the world all the partners were folded into the other firms.

The limitations are you're hired to be a independent to give your independent opinion and attest that the financial statements present fairly in all material respects in accordance with some set of accounting standards and/or standards that's associated with a contract for example. And the challenge is time because you have to do this quickly, pressures on costs and essentially think about it this way.

It's like I tell you, look, I I just prepared my report card. I got an A. I now hand it to you and say, look, it's an A. And if you say that it's an A, I'll pay you X amount of money. So, look at your situation. You come back and say, well, it's actually not an A. It's kind of a B+. Uh, how much am I paying you again?

What do you mean it's a B+? Do you think that question that the way I answered that question couldn't have been this way or the other way you know and this is it ties into so many things you know AI and so forth business is judgment people run companies they don't run themselves the decisions associated with a business transaction end up being reflected on those financial statements but when the group that's making the decision in the business to do something well then they come back to the office and show up in the in the accounting department and say, "Hey, we just did this. You know, can you guys figure out how to account for it?" And all of a sudden, the accountants are like, "God, what do I do now? How do I do this?" Because then they and by the way, when you do this, I want it presented as as, you know, as bright as possible so that our investors and all our stakeholders are really excited by the results like don't present it badly.

You said a lot of people don't read the footnotes or the financial statements. Is that changing in a world of AI where you can sort of like download the financial statement, pop it into AI and say, "What do I need to know?"

I think it's actually exacerbating the situation. because now read the financial statements, Anthony. I just put it into AI. I asked Chat GPT to tell me, "What about this? Look for that. Look for that." And there's there's all the instances of those things. and then I just read it and it's all there. Well, did the AI miss it? Did the AI understand the linkages between each of those sightings?

If I'm if I'm looking at, for example, I was looking at a company recently and I was looking at it was capitalizing costs. Okay, this is a REIT. And if it capitalizes cost versus putting them through the income statement, if it goes through the income statement, it makes their operating earnings look poor, lower, and their net EPS ultimately. But if they put it on the balance sheet, well, you know, that's an investment in the future and everything looks okay, right? And so there's a gray area. Was it an operating expense or was it a capital item?

And so I was first thing I looked for was capitalized interest. And so it gave me all the quotes and then capitalized costs and it gave me all the quotes. So then you think that that's enough, but you have to then and I and I was showing one of my guys this. I said, "So then let's go to the income. Let's actually pull up the statements where it told us to go because AI made it faster. I now no longer needed to flip the 300 pages, but it it gave me where to go.

So now I went there and now I could say well that means if that is what's happened then we need to look at this other note to see what you know the implications of that and then we got to look at the cash flow statement to see how it's actually impacting what ends up being reported as as cash flow and so those linkages come it the AI makes me get to the answer perhaps more quickly but it's my if I don't already know where I want to go then AI just gives me information, but that information doesn't help my decision if I didn't start with where I want to get to.

100%. This is I love it. If that's where investors go and that's where they're going, everything is going to AI. The the bottom level of being an analyst, the junior analyst is is going to be replaced by an AI. the one that said, "Find me all the references of, you know, where the company capitalized costs." That the AI can do. I get it. But you need someone with experience to know what which of those references matter and to what that means to the business.

And this brings about a number of challenges because well if that junior person doesn't learn doesn't get on the in on the ground floor they'll never learn to be able to make all those connections and the only way to learn is sort of like being in the weeds and not being in a Yes. In fact, it ties to so many things.

I I with my own children I've seen growing up when we went to school and we were in elementary school, we would be, you know, we'd have to do the math tables and and recite them. Yeah. 2 * 2 is four and so on. I remember I was struggled with my with my nine times table and then my 12 times table and so I had to memorize them and get them going. But then my children came along and they were using a calculator and apparently that was okay. I went bananas. I said, "You're not going to use the calculator. You need to learn it without the calculator and then you can use the calculator, which is the same with AI. You need to understand how the financial statements are prepared, understand the linkages, develop mental models so that when the AI gives you information, you can you can digest it and make decisions.

Correct. Experience teaches you judgment. And and you talk about this in your book. It's all about the mental models. I I I believe that strongly. The experience teaches you what the numbers mean as we've spoken about. And when you have experience, you say, "I've seen that before."

And a lot of the things I see happening today link back to things I've seen when I started my career over the last 30 years. And I think that's something that the AI can't quite do unless you tell it where to look because it doesn't know the link that I'm thinking about, right? But if I if I can make the initial stage, it can help me get there quicker and more accurately. But if I don't if I don't already have a model of what I'm looking for, it's not going to get there.

I think we're in uh what seems to be, you know, and I I hate calling things bubbles, but I think we're in a period of extreme uh euphoria where the numbers, the fundamentals, and fundamentals is thrown around in the investment industry like the the word love is thrown around among humans. You know, the fundamentals, well, someone looks at the chart and sees that, you know, it did a double bottom. Well, that's the fundamentals. And someone else says, you know, that they're looking at the RSI or some other things or someone else says they're just looking at cash flow or someone's looking at the multiple related to earnings. And those are the fundamentals.

Well, at the, you know, historically, and if we follow what what Buffett says, the company is the present value of its future cash flows. And how do you develop those cash flows? Well, you need to do a forecast on what it's what what it's going to drive the business. And so, that's what I think the fundamentals are. And so when a company today is not generating much in free cash impact negative and yet the market wants to trade it at a multiple of its revenues well then the company's valuations is extracted from its current fundamentals and trading based on some future expectations.

And all I know is I've seen that when you read and speak to investors and they say that the numbers don't matter and the financial statements no longer matter because this is changing the world. I say, "Well, I've seen this before." You know, I saw that Nortell was changing the world and Lucent and Cisco and 360 networks. They were building out the infrastructure of the internet that we're using today. But those companies don't exist anymore. They built what they built and that still exists, but they no longer exist. Either bankrupt or folded into other companies. Cisco still exists today, but has never traded at it at its historical uh valuation. And yet, it's a it's it's a multiples bigger than it was back then and by earnings and by revenue.

I guess what you're saying is the same is we know this is the future, but it's also the same in that we don't know who the winners are going to be. That's right. And and I think right now the reason why I think we're in a in a very high-risisk situation is because the cost of the risk is priced very low and that's when the risk is highest.

And so how do we look at that? When you look at the uh the high yield bond spread, the spread between the 10-year bond and the high yield bond in the US, okay, that's the non-investment grade bonds. Well, that's the tightest, near the tightest it's ever been, which means that investors are willing to lend money to non-investment grade companies at a spread over what a government bond is at a rate, which is the tightest it's been practically in history. So there's no risk priced into the bond market.

And then in the equity markets, we use VIX, which is a measure of volatility of the of the S&P 500. And that is trading at a benign level. It's not the lowest it's ever been, but it's at a benign level. So in essence, what investors are saying is there's no risk. Everything's fine.

So at the time you had Nortell and you had Cisco and you had Lucent and they were building out various components parts of the internet and what they would do was they needed customers. Well the customers needed to raise money cuz if you're going to build infrastructure you're not going to generate cash flow for some time. So they would raise money from equity holders and eventually get some debt but the powers that be at Lucent and Nortell would also offer them.

So they would say buy this $10 million worth of product and why don't you pay me over some extended period of time. Oh, and by the way, we'll give you a line of credit so that you need 10 million from us of of cable. Uh, but we'll you can also you need to buy some routers from Cisco. You know what? We'll give you some line of credit so you could do that because Nortto could borrow money could could had a great balance sheet could raise money whatever. And so that's what was happening.

Well, ultimately when the equity market started to wobble and there was no one left to continue to make sales to, right? Well, then now all of a sudden Nortell didn't get paid on its debts and the wheels came off and then the 360 networks and JDS unif mentioned they went by the wayside.

And so what ended up sort of now let's take that and think about what's happening today. So you have the likes of the Nvidias of the world and let's say Microsoft and you have Open AI and such and Nvidia is investing in Open AI. And Microsoft is an investor in Open AI. Microsoft offers cloud services to Open AI. So it's a customer. So OpenAI becomes a customer of Microsoft. But Microsoft gave it the money so that it could actually pay it back. Nvidia invests in OpenAI and Nvidia is a a a supplier of chips to open AAI. So it's all circular. What's going on here?

There's a new company that just went public earlier this year, Cororeweave, who is its largest customer. Coreeave provides data transaction like analysis of on chips, right? It's a data farm for the large AI users like Microsoft. Its largest customer is Microsoft. Microsoft hasn't invested in it, but Nvidia supplies pretty much all its chips. Well, Nvidia is a large or is a meaningful investor in Coreave. Corewave goes public. It's trying to close its its equity, its financing. on the last moment, Nvidia buys $250 million worth of shares of Cororeweave so that it could close the deal. These are, you know, JP Morgan gives them a loan so that they could just before they go public and then they go public and repay the loan to JP Morgan who's the one of the lead underwriters, JP Morgan.

No one's doing anything bad. No one's cheating. It's just these are all the same type of symptoms of things that were going on way back some 25 years ago. All these things don't mean anything. Nothing means anything until it means something. I say, you know, the things that we're talking about right now, these little things, if you will, you know, in the time of 2000s, just like we talked about Enron, that didn't have the disclosure.

What are the red flags you look for? I like the way you you posed the question because it sets up what I we've learned over time. The problem with red flags is it gets to your point that you started at before where you don't want to be crying wolf. And so I've learned to temper because you could be wrong.

It's not red flags. We call them flammable items. So this goes to the pro our process. It's a three-stage process that we use and we teach because one of our we have Veritasu and so we teach investors how to make better investment decisions. And so the the first stage is you understand the business and the control environment. Okay, again understand and understand the accounting that's being used so that when you study the financial statements, everything else, they all make sense and you understand sort of the the the structure, how is management compensated, what stage of their life cycle are they at? Because those are all sort of constraints and opportunities within the business.

So then you look for a flammable item. For example, companies generating negative cash flow. That could be by itself a red flag in the normal way. This this type of I would call forensic analysis is taught unless you know. So if a company's generating negative cash, it may actually be a fantastic thing. They're investing in an AI startup that is going to be a huge opportunity. and they've shown over time that the return on invested capital is in excess of 20% or 50% or whatever it is. And so they're investing in something. Yes, it's negative cash flow today. But I'm not investing for the cash flow today. I'm investing for the cash flow tomorrow. So you see that as a red flag, you don't invest in it. And unless you understood the first part, which was the fact that where they are in their life cycle, type of business, etc., that is now not a red flag. It's just a flammable item by itself. Not a problem.

It depends. And then you get to the third bucket, which is the spark. And so you're always looking for a spark because let's use that same negative cash flow. Well, if all of a sudden a new competitor comes into that company's operating space, okay, and is able to take market share, now all of a sudden that negative cash flow is a problem. If you notice in the financial statements when you look at that negative cash flow, the company's taken on very expensive debt. Again, very expensive debt by itself doesn't mean anything because if the potential return on invested capital is higher than that cost of capital, it's all good. But if a new peer comes in play, now all of a sudden that model may not work. And now you have a blowup.

We wrote about Valiant. We said sell Valiant. Okay? We're the only cell on on Valiant in 2012 2013. The company didn't blow up until 2015. Okay? But they and they would talk about their integrity and their, you know, how they were changing the world with the with the drug reformulations they were doing and so forth. But if you look deeper, they were just manipulating the accounting and changing the pricing on on drugs and creating a fraudulent network of onlineies.

How did so many well-known wellrespected investors go wrong? People who are known for their due diligence, people who are known for their leg work. I know I sat with them talked to them before the c before it's a situation where someone is such a masterful spinner of a story and is the CEO and the management team sold you had Mike Pearson. and was executing and you know he comes he came from a great pedigree. He was not taking a salary and everything was tied to the stock price. you know, he he was, you know, for tires tirelessly working in the company and he'd proven because what ends up happening is price creates narrative.

So all of a sudden you don't believe it day one, but then you see that they made an acquisition. It didn't seem like it was going to work, but then it works and the stock price goes higher and then they do something else and it kind of seems a little bit strange. And then they changed their accounting and and they changed the way they rec they they present their op their uh non-gash gap metrics which is things we noticed like that's another huge flammable item. The company says you know they're reporting their they use an adjusted IBIDA and they calculate it in a certain way and then the following year they calculate it a different way. Well that's a non audited number. It's a it's whatever management wants and you know the markets just believe it. And so that's something that Valiant was notorious about, but didn't matter because the stock price just kept going higher.

And as the stock price keeps going higher, it's very difficult. Okay, in in the money management industry, when you're underperforming, it is so difficult to stay the course. you saw this you know in the financial crisis that movie about you know the big short like those individuals were became clients of ours like I know Porter Collins if he ever listens here and and Danny and so forth like we we befriended each other during during this time of madness and afterwards it was like they were crazy like you end up looking at yourself going I'm crazy I'm seeing this and nobody cares it becomes so difficult

companies don't start out as being crooked. They have to convince someone to buy a product okay or a service. So money comes in to the company in some fashion or time and then gets converted into something that adds value. The problem becomes outside stakeholders come in and say, "Well, I need you to make X because you want my money. Well, I'll give you my money so long as you give me this return." Well, that works until there's a problem. And now there's no CEO that wants to disappoint.

So, it's very simple. The CFO comes to talk to me. I'm the CEO. And he says, "Look, I know uh Anthony, we were going to make a dollar, but we're coming in at 95." And I say to him, "You get back to your room and find me 5 cents." You like your job. You like your kids going to private school. You like your stock options, how much they're worth. You see all these employees we have, they we give them stock as a part of their compensation every quarter. Like that's a problem. We can't disappoint. And then it starts

It always starts slowly. And look, there that was what Andy said in in the I think correct those interviews. It's like, you know, it started with a little bit and I figured next quarter I could bring it back and it's just, you know, that's the thing. Life is a dangerous thing this way. Whether we push something even in life, right? You know, well, look, if I smoke a bit or drink a bit or tell this little lie, you know, no one notices and I'm I'm okay. Well, then maybe I do a little bit more of each one of those things and no one notices and then it's all good, right?

I hate them personally in public companies. However, I I understand why companies want to use them. I mean, my take is there, you know, if you look at most buybacks, they're just covering up stock options. Correct. Very good.

I think that uh stock options what they do every it comes down to human motivation. So if I am going to compensate you on the stock price, then you're going to make decisions that move the stock price. I think stock options should be an expense and if they're not an expense I I borrow from Buffett and even the chair of accounting has said things like this that that if it's not an expense then what is it? You can choose to pay someone in stock options or you can choose to pay them in cash. So if I pay all my employees, you pay, you have the same company, you're we're a competitor. You pay all your employees with stock options. I pay them in cash. I have a lower EBIDA. I have a lower EPS. Your stock trades higher than mine. Stock price goes down. All of a sudden, all your employees leave and they want to come work for me. And all my guys are pretty happy. They don't care.

So when you buy back stock, the company is making a investment in a security. Which it partially has control over what it does, but it doesn't have full control over what happens to that investment value. Whereas if it takes its cash and buys an an operating asset that expands its current production and if it's already generating a meaningful return, then that return should continue and expand. So to me, it's a it's a point that says I have no other investments in my business that would generate a return higher than my cost of capital. And so I'm going out and buying my stock and I think that is very risky.

Buffett has built a business that generates cash so he has operating businesses Gecko Pulum etc these generate cash he takes that cash and invests it when he wants to invest it in the way that he wants to invest it. You know, the average portfolio manager can't do that because they're tied to they have to like today in the investment management industry, portfolio managers are measured like on a daily basis there.

Part of the reason that Berkshire was able to do that and Buffett was able to act is that or Buffett's able to do what he's doing today is he controls so much of the shares. So he's got the structure to enable the strategy to play out. Whereas if you think about it, you know, there's many times during Brook Birkshshire's uh long career where an investor, an activist investor would have come in, demanded they return capital, demanded they take on debt to buy back shares, and the structure that's enabled so much success has also prevented that.

when if the market falls uh or or suffers some kind of setback, you shouldn't be concerned. You shouldn't be you shouldn't be scared. In fact, I I did a trip to China uh life-changing practically earlier this year. I'd never been before. And um when I went to China, I if you go and in the and I um met with analysts there and taught them our our training process. And if you when they when they look at their screen, stocks that are down are green, stocks that are up are red. That's how you should rejig screen. In fact, I called fact set in and Bloomberg and see if we can change that. Because if you look wake up every day and everything's red and you like we lived this in '08, right? It went lower and you thought, "Okay, I'll buy some now." And then it went lower two early 2000 and then it went lower until you don't know what that feels like until you go through it. But imagine if every day it was green. You go, "Oh, this is interesting." And if every day it was going up, it was red. You'd go, "Hm, I'm not sure. Is this okay? Is everything okay? It might be, but it's just everything's a mindset, right?

they think that AI is going to beat us as investors. I say bring it. It's all good. Bring it. It's just a tool. We're still human. It's a tool. It doesn't have judgment. It doesn't have the ability to, you know, make decisions on past links that unless it unless that link that it drew, but you don't even know what link it drew.