Budget Feedback, the Patient Capital Review and Productivity

My last post was on the Chancellors Budget which was written quickly but seems to have covered most of the important points. Perhaps one significant item missed was the additional liability of foreign investors for capital gains tax on property sales, although institutional investors may be exempt. This might have some impact but as the details are not yet clear, it remains to be seen what.

Otherwise the media feedback on the budget was generally positive although there was a big emphasis on the poor economic forecast for growth that the Chancellor announced. The OBR has substantially reduced growth forecasts which is one reason why debt will not be falling as quickly as previously indicated and future tax revenues will likewise be lower. Part of the problem is a failure to improve productivity. This also means that average wages in real terms may not grow as expected.

Why did I not comment on this? Because firstly economic forecasts (the OBR or anyone else’s) are notoriously unreliable, and secondly it makes little difference to most UK investors. It might suggest it would be wiser to invest more in overseas companies than UK ones, but in reality many UK companies have major revenues and profits from abroad. In any case, a lot of investors have already hedged their portfolios against the possible damage of a “hard Brexit” by adjusting their portfolios somewhat.

My experience is that investing based on country economic forecasts is very questionable. Good companies do well irrespective of the state of the general economy.

Patient Capital Review

On Budget day the Government (HM Treasury) also published their consultation response to the “Patient Capital Review” – or “Financing Growth in Innovative Firms” as it is officially called. You can find it on the internet. This review was aimed to review incentives to invest in early stage companies with a view to promoting more investment in such companies as part of the attempt to improve productivity in the UK economy. It potentially had significant impacts for investors – for example on the EIS and VCT tax reliefs. What follows is an attempt to bring out the key points:

The review considered not just the tax incentives, and whether they were effective, but whether more direct investment (supported directly or indirectly by the Government) should be undertaken. They got more than 200 written responses to the original consultation on this subject (see mine here: http://www.roliscon.com/Roliscon-Response-to-Financing-Growth-in-Innovative-Firms.pdf ), plus some on-line responses and they also used a panel of industry experts.

Although they have not published all the responses or broken them down in detail, one gets the impression that most respondents considered that the VCT/EIS regime was generally effective in stimulating investment in early stage companies and that there were few abuses. But the Treasury had expressed concern about some of the investments made in EIS/VCT companies which were often focussed more on “asset preservation” than in funding new growing businesses. So the rules are being tightened in that regard – see below.

A personal note: having invested in two EIS schemes that promoted country pubs the asset preservation capability might have made for a good sales pitch by the promoters but they subsequently turned out to be very poor investments even after the generous EIS tax reliefs. One is being wound up with the assets being sold for much less than purchased while the other one only made any money after it turned into a bailiff business subsequent to a shareholder revolt. The Government’s policy of ensuring a focus on “riskier” investments might actually be good for the investors as well as the economy! It will avoid inexperienced investors getting sucked into dubious investments by sharp promoters who can make even lemons sound attractive because of the generous tax reliefs.

On the support for new investment front, the Government is taking these steps:

  • Establishing a new £2.5 billion Investment Fund incubated in the British Business Bank with the intention to float or sell once it has established a sufficient track record. By co-investing with the private sector, a total of £7.5 billion of investment will be supported.
  • Significantly expanding the support that innovative knowledge-intensive companies can receive through the Enterprise Investment Scheme (EIS) and Venture Capital Trusts (VCTs) while introducing a test to reduce the scope for and redirect low-risk investment, together unlocking over £7 billion of new investment in high-growth firms through EIS and VCTs.
  • Investing in a series of private sector fund of funds of scale. The British Business Bank will seed the first wave of investment with up to £500m, unlocking double its investment in private capital. Up to three waves will be launched, attracting a total of up to a total of £4 billion of investment.
  • Backing first-time and emerging fund managers through the British Business Bank’s established Enterprise Capital Fund programme, supporting at least £1.5 billion of new investment.
  • Backing overseas investment in UK venture capital through the Department for International Trade, expected to drive £1 billion of investment.
  • Launching a National Security Strategic Investment Fund of up to £85m to invest in advanced technologies that contribute to our national security mission.

In addition the Pensions Regulator will clarify guidance on inclusion of venture capital, infrastructure and other illiquid assets in portfolios and HM Treasury will encourage defined contribution pension savers to invest in such assets.

Entrepreneur’s Relief rules will be changed to reduce the disincentive to accept more outside investment, and the Government will also look at a guarantee programme modelled on the US “Small Business Investment Company”.

They will also work with the Intellectual Property Office on overcoming the barriers to high growth in the creative and digital sector. What this implies is not clear. Does that mean they are suggesting introducing software patents perhaps?

Several gaps in the investment market for early stage or follow-on funding were identified but one telling comment from the expert panel was this: “…the UK venture capital market has historically delivered poor returns; this results in less capital being attracted to the asset class, which in turn results in less talent being attracted to the patient capital sector; this then depresses returns, completing the circle”. But they did suggest this could be fixed.

There apparently were many comments on the importance of the EIS/SEIS schemes for funding innovative businesses – for example: “EIS and SEIS incentives have been particularly effective at stimulating investment and are extremely valuable to bioscience investors”. But I suspect that has been of more benefit to companies raising capital than it has been in terms of achieving long-term positive returns for investors. It is a pity not more evidence was provided on that.

The Treasury response is to double the annual investment limit to £2 million for EIS investors, so long as any amount over £1 million is invested in knowledge-intensive companies. Also the annual investment limit for knowledge-intensive firms will be doubled from £5 million to £10 million for EIS and VCT companies, and a new fund structure for such firms will be consulted upon. There will also be more flexibility on how the “age limit” is applied for companies applying. Question: what is a knowledge-intensive company? The answer is not given in the Treasury’s response.

A “principles-based” test will be introduced for all tax-advantaged venture capital schemes. This will ensure that the schemes are focussed “towards investment in companies seeking investment for long-term growth and development”. Tax motivated investments where the tax relief provides most of the returns to investors will be ruled out in future. There must be “a risk to capital” for firms to qualify. Detailed guidance will be published on this and there are some examples given in the response document, although it is far from clear from those what the rules might be. Comment: as this is going to be “principle-based” rather than based on specific rules it looks like a case of the Treasury saying “we can’t say what is objectionable now but we will know when we see it”. This might create a lot of uncertainty among VCT and EIS fund managers and company advisors.

The rules for VCT investments will also be tightened up with the following changes:

  • from 6 April 2018 certain historic rules that provide more favourable conditions for some VCTs (“grandfathered” provisions) will be removed
  • from 6 April 2018, VCTs will be required to invest at least 30% of funds raised in qualifying holdings within 12 months after the end of the accounting period
  • from Royal Assent of the Finance Bill, a new-anti abuse rule will be introduced to prevent loans being used to preserve and return equity capital to investors. Loans will be have to be unsecured and will be assessed on a principled basis. Safe harbour rules will provide certainty to VCTs using debt investments that return no more than 10% on average over a five year period
  • with effect on or after 6 April 2019 the percentage of funds VCTs must hold in qualifying holdings will increase to 80% from 70%
  • with effect on or after 6 April 2019 the period VCTs have to reinvest gains will be doubled from 6 months to 12 months

Comment: these changes would not seem to cause great difficulties for VCT managers and should not affect the returns to investors. Some of the changes might be helpful. The feedback from VCT managers is awaited.

But the income and capital gains tax reliefs for investors are basically unchanged, as is Business Property Relief on “unlisted” companies such as AIM stocks which were both mooted as being under consideration. As I wrote in my previous blog post on the budget, at least the Chancellor and the Treasury seem to have minimised the changes which is always helpful for investors. Being unable to plan many years ahead because of taxation rules and levels continually changing has been a major problem for investors. So on that score alone, the budget is to be welcomed.

As regards Entrepreneurs’ Relief, the government is concerned that the qualifying rules of Entrepreneurs’ Relief should encourage long-term business growth. The rules will therefore be changed to ensure that entrepreneurs are not discouraged from seeking external investment through the dilution of their shareholding. This will take the form of allowing individuals to elect to be treated as disposing of and reacquiring their shares at the then market-value. The government will consult on the technical detail. Comment: this seems to be yet another complication to taxation rules which is unfortunate.

Productivity

These changes to the tax incentivised schemes, and the Government investment in funds, may assist to improve the productivity of the UK population by focussing on high growth technology businesses. One cannot improve productivity by employing more coffee bar baristas, and such jobs are always likely to remain low paid. The budget change to increase the National Living Wage (the Minimum Wage) from next April will also promote improvement in productivity as it will make employers consider investment in automation rather than simply employing more staff.

There is also investment in infrastructure committed to in the budget, which might assist. Is it not the case that productivity is reduced because of the distances and time wasted in commuting in the South-East of England? The transport network (road or rail) is truly abysmal in the UK and has been getting worse. This means that folks are tired before they even get into work. The encouragement of commuting by cycle also surely results in tired and unproductive staff. It might be fashionable, and good for their health in the long term, but is it good for the economy? Unfortunately the housing market has been made more inflexible in recent years in some respects so people cannot move nearer to their workplace. Stamp duty increases have deterred moving to reduce travel costs, and higher house prices in some areas have not helped. For example, this writer recently met someone who lives in Southampton when his employer was based in Oxford – he could not afford to move. The reduction in stamp duty for first-time buyers in the Budget is not going to make a big difference to these problems.

So overall the Budget changes are more “nudges” in the right direction to improve the economy, while not being revolutionary. The Government’s tax base is not undermined and investors tax planning not significantly affected, so Philip Hammond may find he is in the job longer than expected after all.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Chancellor’s Budget and How It Affects You

What follows is a summary of Chancellor Philip Hammond’s Budget speech today, and the impact of the tax changes. Private investors were particularly concerned about the impact of tax reliefs in the VCT/EIS schemes following the Patient Capital Review but these are in fact relatively minor (see end of document).

This is a summary of the key points he announced:

  • The Chancellor said we are on the brink of a technological revolution, we must embrace it. Britain is at the forefront, but we must invest to secure it.
  • Regrettably our productivity performance remains disappointing.
  • Our debt interest is too high. OBR expects debt to peak this year and fall thereafter.
  • He maintained his commitment to fiscal responsibility but will use the headroom to prepare Britain for the future.
  • The strategy is to raise productivity and employment in all sectors of the economy. A white paper will be issued on this within a few days.
  • Following the Patient Capital Review an action plan will be published which commits to more funding of the British Business Bank, including £2.5 billion of Government seed funding (to co-invest with private firms). But there will be some restrictions on EIS tax relief (see later).
  • First year VED on cars that do not meet the latest emission standards will be increased. However there will be no “benefit in kind” from the provision of free electric charging of vehicles at work.
  • There will be more support for maths teaching including specialist schools. More maths for everyone! And there will be a tripling in the number of computing teachers. There will also be more “distance learning” support.
  • Universal credits will be paid more quickly and there will be easier access to advances to overcome complaints in this area.
  • The National Living Wage will rise by 4.4% from April (Comment: this will obviously impact employers of large numbers of low paid staff such as retailers and hospitality firms).
  • The Personal Tax Allowance will rise to £11,850 from April and the Higher Rate Threshold will also increase to £46,300, in line with inflation.
  • Taxes on beer, wine and spirits will be frozen (apart from cheap cider). A Merry Christmas to all. Fuel duty will also be frozen.
  • An additional £10 billion of capital investment will go into NHS frontline services. That includes £7.5 billion this year and next, plus there will be a review of staff pay.
  • There will be more attacks on tax evasion. In addition, the anomaly of the indexation of capital gains for companies (but not individuals) will be removed.
  • The VAT registration threshold will be reviewed but it is not intended to amend it from the current £85,000 level for at least two years.
  • There will be amendments to business rates to help smaller businesses.
  • There will be a review of international taxation arrangements. Royalties paid to low tax countries will be taxed and on-line marketplaces will be jointly liable for the sellers VAT.
  • Councils will have powers to tax empty properties, plus the Government will look at barriers to long tenancy agreements.
  • The Chancellor said house prices are getting out of reach. Successive Governments over decades have failed to meet the demand for housing (comment: surely nobody can dispute that). He committed £45 billion in capital and loans to boost the supply of skills, resources and building land. Plus there will be reforms of the planning process/laws. There will also be an inquiry into why plots with planning approval are not built.
  • Seven new town developments are planned with 1 million new homes in the Cambridge, Milton Keynes, Oxford corridor. The plan is to build 300,000 new homes per year.
  • Stamp duty will be abolished on the homes up to £300,000 in price for first time buyers and the same allowance available for homes up to £500,000 in price.

More details on taxation changes.

Changes additional to those mentioned above include:

  • The IR35 rules allowing contractors to avoid being taxed as employees may be tightened further (to follow through changes in the public sector to the private sector).
  • There will be a consultation on reform of the taxation of trusts to make them simpler, fairer and more transparent (Comment: surely a positive move).
  • Individuals operating property businesses will have the option of using mileage rates to simplify their tax affairs.
  • ISA subscription rates will remain unchanged (£20,000 for 2018-2019).
  • Lifetime allowance for pensions will be increased by inflation to £1,030,000.
  • Carried interest transitional arrangements will be removed with immediate effect (so pity those asset managers who will now pay full capital gains tax rates).
  • The restriction of relief on VCT investments sold within six months where VCTs merge will no longer apply to mergers more than two years after the subscription or where they do so only for commercial reasons. This will avoid a trap that investors can accidentally fall into.
  • VCT and EIS schemes tax relief will need to ensure they are investing in assets subject to “real risk” rather than those simply aiming for “capital preservation”. Certain “grandfathering” provisions that enable VCTs to invest funds under older rules will be removed from April 2018.
  • VCTs will need to invest 30% of new funds raised to be invested within 12 months.
  • VCTs will need to have 80% of their funds as “qualifying” investments (currently 70%) from April 2019, but they will have 12 months to reinvest the proceeds of disposals (currently 6 months). This presumably might enable them to smooth dividend payments somewhat when currently they often have to pay out the result of realisations rapidly.
  • EIS rules will double the limit on the amount an individual can subscribe in a year to £2 million, but any amount over £1 million must go into “knowledge intensive” companies. Comment: I await some simple definition of what they might be. Such companies will also have the limit on annual EIS and VCT investments raised to £10 million

I have only included what seem to be the most significant changes in the above. In general there seems to be a policy to avoid rapid and abrupt changes to taxation (which thwart people from planning their tax affairs) which is to be welcomed.

Whether the VCT and EIS tax changes will have significant impact on those vehicles remains to be seen although some of the changes had already been indicated and threats of major changes that had been rumoured seem to have been avoided. This writer expects that the managers of those funds will adapt as they have already been doing. Encouraging investment in riskier assets may increase the risk profile of those companies but might also increase the returns and a large size and diverse portfolio will provide a hedge against the risks.

The full report on the Patient Capital Review consultation has also been published and is available here: https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/661398/Patient_Capital_Review_Consultation_response_web.pdf

I may provide further comments on that after reading.

In summary I view this budget positively with no unexpected surprises or likely perverse outcomes from unintended consequences we have seen from the surprises announced by previous Chancellors. But it would be interesting to get readers comments – please add.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Standard Life UK Smaller Companies and FRC Meetings

Yesterday I attended two meetings in the City of London. Here are brief reports on each.

Standard Life UK Smaller Companies Trust Plc (SLS) held a meeting for investors to “meet the manager” in London as their AGM was in Edinburgh this year – only about 10 people attended the latter so there were more in London. I have held this trust for some years and the manager, Harry Nimmo, who has been with the company for 33 years has been a consistently good performer. The management company has recently merged with Aberdeen and is now called Aberdeen Standard Investments but apparently there have been no significant changes internally as yet. Mr Nimmo’s comments are summarised below.

He said they have a discount control policy which is unique to UK smaller companies trusts. They buy back shares if the discount gets about 8%. The investment policy is unchanged and they are not keen on blue-sky or concept stocks. AIM is now a better place than 5 years ago as it is now more broadly based and no longer dominated by mining stocks and blue sky tech stocks.

They have put a new debt facility in place which will ultimately replace their CULS (Convertible Unsecured Loan Stock). The final date for conversion is coming up and investors need to pay attention to that as they are “well in the money”.

The trust shows a ten year CAGR dividend growth of 23.7% and the capital return since 2003 is 851% (plus dividends of course). But there have been some bear markets during his management which one needs to allow for as investors. However, if you had sold the trust after the Brexit vote you would have made a terrible mistake – the company is up 54% since June 2016.

The trust looks for companies that can grow irrespective of the economic cycle, and those with good cash flow and strong balance sheets. Mr Nimmo covered their investment process which is somewhat formulaic using a screening process (I have covered it in past articles) but they do meet investee companies twice a year. They have about 50 holdings in the fund which is a “bottom-up” stock selection actively managed fund.

He mentioned they have 10% in animal care and still hold NMC although as it is now a FTSE-100 stock they have been selling out. They still have a large holding in Abcam and have bought RWS recently. Their second largest holding is First Derivatives where most profits come from outside the UK. They generally do not hold oil/gas/mining stocks and are very light on real-estate [note: I agree with the former and many of my individual holdings overlap with the trusts but I do hold some real estate companies]. An exception though is Workspace who recently produced an excellent set of results with a rapid growth in dividends.

They have also been selling Fevertree as it exceeded 5% of their portfolio value.

I did not manage to stay until the Q&A session as I had to go to a meeting organised jointly by ShareSoc and UKSA with the Financial Reporting Council (FRC). This was a long meeting and I hope one or other organisations will produce a lengthier report on it because it was an exceedingly useful meeting. I will simply highlight a few points of particular interest.

FRC Meeting

The FRC is responsible for audit policy, standard setting and audit quality including investigation and enforcement of past transgressions. So it is a rather important body for those private investors who have come unstuck on an investment because the accounts of the company turned out to be misleading – for example the recent debacle at Carillion was mentioned by one attendee, but I can think of numerous other examples.

The speakers covered the role of audits, both currently and how they might develop in the future (partly as a result of technology changes such as the use of data analytics). After Brexit it is likely there will be a broadly equivalent regime as investors are opposed to “unpicking”.

The FRC reviews about 150 audits every year and grades them into four categories (the reviews are listed on the FRC web site). By 2019 they want 90% to be in the top two ratings which they are not at present. It was noted that KPMG come out worse of the big audit firms. A common reason for audits falling short are lack of professional scepticism.

The FRC also undertakes thematic reviews of particular issues. I raised the issue of the lack of common standards for “adjusted” data commonly reported by companies (such as earnings, or return on capital that I mentioned in previous recent blog posts). The response was it was mandated to explain the definitions of such adjustments but I pointed out this did not help with comparability (e.g. of broker forecasts). The FRC said they will be consulting on this issue shortly, which is good news.

The role of the FRC in “enforcement” was covered. They stressed that their remit does not cover crime, they merely regulate accountants and actuaries although it is of course true that the failure of auditors to identify false accounts is one area they often investigate. It was mentioned that the size of the team on this had grown from 11 people in 2013 to 30 now and they are still looking for more bodies. This really just shows how under-resourced the FRC has been in the past. A total budget of £15m per year was mentioned. Comment: this seems hopelessly inadequate to me bearing in mind the number of public companies (and other organisations) and the number of auditors they have to monitor. It explains partly why complaints to the FRC often seem to disappear into a black hole, or why investigations often take so long as to be pointless. A list of cases under formal investigation is on the FRC web site (See here for that and two linked pages for the full list: https://www.frc.org.uk/auditors/enforcement-division/current-cases-accountancy-scheme which of course will tell you that Globo was commenced in December 2015 and Quindell in August 2015 and have yet to report).

I did suggest to the speaker that the FRC should be a party to the Code of Practice for Victims of Crime (as some audit failures involve the crime of fraud) as the Police, the SFO and FCA are, and which has improved their disclosure culture. This might assist those who report failings to get some feedback on the progress of a case. But the FRC argue that their role is not to investigate crime as such and they are inhibited by legislation/regulation on what they can disclose. However it is very clear to me that too often complaints get made to the FRC, but the complainants are not advised of progress and often have no idea on the outcome. This is an issue they will be looking at.

They hope the extra staffing will speed up investigations. The investigation process was discussed, but for example, Carillion had not even been placed under formal investigation as yet. It was suggested by audience members that the FRC was quite ineffective but recent cases such as AssetCo and Healthcare Locums were mentioned as demonstrating strong action and they have issued fines of £12 million in the last year which is the biggest ever. It was mentioned that fines go to the Treasury which is not ideal.

Confusion between the different regulatory bodies (e.g. the FRC, FCA, SFO, etc) was mentioned by attendees and the speakers, not helped by similar three letter acronyms. One attendee suggested that a unified regulatory body would help (such as the SEC in the USA). Comment: I agree at present it is unclear except to experts on who is responsible for what and the accountability of these bodies to the Government or to any democratic body of investors.

The FRC also has an interest in the UK Corporate Governance Code and the Stewardship Code. A consultation on a new Corporate Governance Code is imminent. There was also a session on the role of the Financial Reporting Lab where both ShareSoc and UKSA members have been involved in the past.

I’ll have to stop here because the budget speech by the Chancellor will commence soon and I wish to listen to it as there may be some major changes on investment tax reliefs. I’ll do another blog post later on it.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Halma and Return on Capital

Yesterday I talked about Diploma (DPLM) and their calculation of adjusted return on capital. This morning Halma (HLMA) published their half year results and they also have a strong emphasis on return on capital, but in this case they call it “ROTIC” (Return On Total Invested Capital). This was down slightly at 13.4% and they define it as Adjusted Profit After Tax divided by Total Invested Capital. The latter is shareholders funds, plus retirement benefit obligations, less deferred tax assets, plus cumulative amortisation of acquired intangible assets plus historic adjustments to goodwill. This similar to the Diploma definition but it is not clear whether it is exactly the same and they call it something different.

As almost every company now reports “adjusted” figures of one kind or another, and analyst forecasts of earning are also usually based on adjusted profits, would it not make sense to have some standard for such data? That’s in addition to the current “statutory” figures which are mandated by the Financial Reporting Council (FRC).

Some of these adjustments, like the ones above in the case of Halma to calculate return on capital make a lot of sense if you wish to obtain a somewhat different view of a company’s performance. But some do not – for example I commented negatively only recently on the figures reported by National Grid.

The FRC would be the best body to set such standards, although they appear to have avoided doing so in the past. Now it just so happens I am attending a meeting with the FRC organised by ShareSoc/UKSA later today and if I get the opportunity I will raise this issue. It would certainly help investors if companies, financial analysts and information web sites reported such adjusted data in a consistent manner, would it not?

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Diploma (DPLM) and Return on Capital

Diploma Plc, a supplier of specialist technical products, issued its preliminary results for the year to the end of September today (20/11/2017). This company may not be a household name and hence can fall under the radar of investors. But it has demonstrated a consistent track record in recent years. Today was no exception. Adjusted earning per share were up 19%, and revenue was up 18%, although a significant proportion of the improvement was down to currency movements (they are a very international business and the falling pound has no doubt helped). The share price has risen 10% on the day at the time of writing.

But why do I like this company? Apart from the track record, the directors have a strong focus on obtaining a good return on capital both from their on-going businesses and from acquisitions. But which measure do they use (Return on Equity – ROE, Return on Assets – ROA, or Return on Capital Employed – ROCE. These are all useful measures, and you can no doubt look up their definitions on the internet. But they use none of the above. They actually report “Return on Adjusted Trading Capital” – ROATCE. This they report as improved to 24% (their target is to exceed 20% which they have beaten in the last five years – that’s certainly the kind of figure I like to see).

How do they calculate this figure? I quote from the announcement: “A key metric that the Group uses to measure the overall profitability of the Group and its success in creating value for shareholders is the return on adjusted trading capital employed (“ROATCE”). At a Group level, this is a pre-tax measure which is applied against the fixed and working capital of the Group, together with all gross intangible assets and goodwill, including goodwill previously written off against retained earnings.”

Personally, I don’t think one measure of return on capital is particularly better than another. Return on Assets is good enough for me although it certainly helps that the company has added back write-offs of goodwill from past acquisitions to save one working it out for oneself. For a company that does repeated acquisitions, these “disappearing” assets are worth bearing in mind. Return on Equity might be considered by some as the most important for equity investors, but using that as a target by management can result in risky behaviour such as gearing up with debt. Bank directors were often keen to talk about that number before the 2008 crash.

Why is return on capital so important? Because when one invests in a company, you are investing in the expectation of a future return. How much they can generate in returns from the assets under their management is a key measure (that’s ignoring the profits from investment from getting a greater fool to buy your shares in a game of “pass the parcel”). I learned this was the best measure of the quality and performance of a company when I went to business school, and I never forgot it when I ran a business. In the modern world, it can be easy to borrow capital and blow it on expansive plans. This can help the management increase their salaries. But for equity investors, it dilutes your returns and you lose the benefit of compounding the retained profits.

The best, and shortest book, that explains this in layman’s terms is Joel Greenblatt’s “The Little Book That Beats The Market”. He uses return on capital (as he defines it) in a calculation of a “Magic Formula” for success. But of course using a simplistic formula has its dangers. If everyone followed it, prices might be driven up to unreasonable levels on the stocks chosen by such a formula. In addition I just looked at the stock list that Stockopedia suggests would be “buys” using the Magic Formula. It results in a mixed bag of shares. For example, it includes Safestyle which I also own when that company’s share price has been falling of late due to concerns about the retail market for large general merchandise items (they sell replacement windows). It might be a “BUY” now but it could also be a share where you could wait a long time for it to return to favour. So the moral is, use return on capital as one measure of the merit of a company, but look at other factors also. In addition, bear in mind that sometimes the market can favour other companies, such as those with little profits in a go-go bull market, or those with massive, if underutilised, assets in a gloomy bear market. So the Magic Formula is best applied to a basket of shares and you might need patience over some years to see the benefits realised.

Lastly, financial numbers do not tell you everything about a company. The historic numbers can be inflated by clever, or false accounting. And they can ignore major strategic or regulatory challenges that a company faces that might not be reflected in historic numbers.

But a company whose return on capital is low is certainly one I like to avoid. It is also helpful when the management talk about return on capital as having importance in their business strategy, and Diploma certainly do that. I consider that a positive sign because if they stick to it, then it should ensure the overall financial profile of the company remains positive and that profits will grow.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Should You Invest In Art?

Following the sale of a Leonardo da Vinci painting for $450 million, those readers who like to speculate might think that investing in art may be worth trying. This was a painting that sold for only £58 in 1958, perhaps because its authenticity was doubted and it had been “overpainted” in some areas. It’s now been restored but it’s far from perfect even so.

It is now the most expensive painting ever sold. Back in 1987, the most expensive painting ever sold was “Irises” by Van Gogh for $54 million (Wikipedia has a list of the most expensive paintings if you wish to follow how these blockbusters have gone up in value, but it is not a smooth progression). Potential buyers of these rare, or unique, paintings which will fetch stratospheric prices should however best leave this market to professional dealers.

But is investment in lower price paintings sensible? Fine art has steadily increased in value so in the long term you can probably expect to beat inflation. But particular genres can go in and out of fashion which could easily add or subtract 50% of the value. In addition you have high trading costs. Auction costs can add 30%, and the market is hopelessly illiquid. Making a sale even at an auction can be a hit or miss affair. If you buy paintings direct from a dealer and are paying “retail” prices then it may take you years to recover the value when you sell because of dealers’ high mark-ups (retail prices are typically higher than auction prices).

The best quote on this subject was probably this one from Lew Grade: “When a little girl asked me what two and two make, I’m supposed to have answered – it depends whether you’re buying or selling”.

In summary if you wish to buy art to hang on your living room wall, then OK. You may gain some tax advantages as it will be considered a “chattel” if you ever come to dispose of it. But as an investment, art is far from the best choice.

For more information on the valuation of paintings (written when Van Gogh’s Irises was the most expensive painting), see http://www.panvertu.com/valuation.htm

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Preparing for Brexit

Apparently MPs on the Public Accounts Committee are very concerned that a new Customs Declaration Service will not be ready in time for Brexit – at least this was in a report in the Financial Times, assuming it is not another of their scare stories. The timescale is indeed somewhat tight to get the new system in place before the likely Brexit date, particularly if one bears in mind that many Government IT projects overrun.

Inability to process export declarations quickly could result in massive queues of traffic awaiting clearance. I recall a previous suggestion that lorries might be backed up along the M20 as far as the M25 which would certainly personally inconvenience me.

But I have some experience of implementing major IT systems for HMRC (or Customs and Excise as it then was) as I was involved in the implementation of the VAT system back in 1973 (when we joined the EEC at the same time). This was a project commenced two years earlier. It had to go operational on time, and it did so without a hiccup. One of the more successful events in my IT career although I only played a minor part in it. The key point I wish to make is that fixing a date when it had to go live concentrated everyone’s minds on the project, and it ensured the best expertise was available to deliver it. The VAT implementation project, which affected not just tax collection work by the Government but also almost all UK businesses was one of the biggest and most important Government IT projects ever completed.

Now when Mrs May decided to fix a specific date for when we will be leaving the EU, to my mind this was a wise thing to do. It will focus those responsible for the supporting systems to enable this to happen smoothly (whatever the nature of the deal, if any, finally agreed with the EU for post-Brexit trade arrangements) if a date is fixed now.

But yesterday the Daily Telegraph ran a front-page story on the “Brexit Mutineers” who were planning to revolt against a fixed date, and as a way to undermine Brexit it was suggested. Lots of other news channels covered the story and one of the mutineers, Bob Neill my local MP and one of the “mutineers”, appeared on television to suggest it was simply the normal democratic scrutiny process. The revolters also signed a letter printed in today’s Telegraph saying a fixed date was too inflexible. There may need to be last minute extensions to conclude a transitional deal. I beg to differ. A fixed date will concentrate the minds of both British and EU Brexit negotiators, which could be of course the reason for Mrs May’s decision.

On both political grounds, and to help those implementing the required systems, fixing a date is the right thing to do in my opinion.

Meanwhile the FT has an editorial supporting the “no fixed date” revolt, and they also published several letters today opposing Brexit. All I can do is yawn at their persistence in ignoring the realities of the situation.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Abcam AGM, Cambridge Cognition, Ultra Electronics, Wey Education and IDOX

Yesterday I attended the Annual General Meeting of Abcam (ABC) in Cambridge as I often do as I have held the stock since 2006. Share price then (adjusted for consolidation) was about 50p and it’s now about 950p so I like most investors in the company, I am happy. Alex Lawson will be doing a full write-up of the meeting for ShareSoc so I will only cover a few points herein.

One shareholder expressed concern about the rising costs. The company is clearly making heavy investments in new infrastructure and more management. Although revenue was up 26.5% last year, earnings per share were only up 11.8% (unadjusted) and operating margin has been falling. Also Return on Capital Employed (ROCE) has been falling – only 12.3% last year when it used to be in the high teens.

Apart from opening a new building next year, they are implementing an Oracle Cloud software solution to replace their historic purpose-built legacy software systems. The total cost of that project is £44 million (see page 23 of the Annual Report) when profits last year were only £42 million post tax. In other words, all of last years profits could be taken to be consumed by this project. This project has been running for some time and I have asked questions about it in previous years. This year I asked: “is the project on schedule and on budget”. I did not get a straight answer. But it was said that initial cost estimates have expanded, and additional modules been added (for example warehouse management). It should “go live” in the current financial year. From those and other comments made, I got the impression that this is a typical IT project that is too ambitious and costs are escalating while delays have arisen. Those “big bang” IT projects rarely go according to plan, but management are often suckers for them.

Now it may be arguable that older systems need replacing (for example, the CEO mentioned it was impossible to bill in Swiss francs that at least one customer would prefer), and maintaining old code was clearly proving to be difficult. The massive investment in this area alone may be justified by the company’s ambitions to “double the 2016 scale by 2023 by investing in operating capabilities” as the CEO mentioned. The expectation is that growth will improve revenues and hence margins in due course.

One more way that costs have been rising is increased pay for management. CEO’s pay alone up from £614k to £1,378k in the last year (“single figure remuneration). In addition, I commented negatively on the fact that the LTIP target had been adjusted for the “scale and complexity of the transformational programme” of the new ERP system implementation, i.e. costs are much higher than expected so the LTIP target has been made easier to achieve!

At least Louise Patten (acting Chairman now after departure of Murray Hennesey for a proper job, and Chair of the Remuneration Committee) admitted later that LTIPs are often problematic but institutions like them. LTIPs at Abcam have rarely paid out, and management at many companies seem not to value them highly. There are better bonus scheme alternatives.

I also spoke briefly to a representative of Equiniti, the company’s registrar, about the difficulty of voting electronically. He is to look into it. Amusing to see the company slogan on his business card is “Our mission is making complex things simple”, exactly the opposite of my experience!

In the morning I also visited Cambridge Cognition (COG) who have offices in the village of Bottisham east of Cambridge. Although their offices are in what appear to be wooden huts, they are well furbished. The company specialises in cognitive health (brain function). Sixty per cent of its revenue comes from clinical trials for pharmaceutical companies, thirty per cent from research institutes and academia and ten per cent from healthcare and consulting.

On clinical trials they do about 15 deals a year so by their nature they are lumpy one-off deals. Total revenue was £6.8 million last year. Before last year revenue was flat but it grew last year and is forecast to grow this year.

A lot of pharma companies are actively researching alzheimers and other degenerative brain diseases, and developing products to assist – as the population ages such diseases are becoming more prevalent. Cambridge Cognition’s technology relies on historically well validated studies. The company provides a lot of consulting support in clinical trial sales.

Such deals include 30 to 40% of software which is billed and paid for on normal 30+ days terms, with the services paid for as provided. One issue that arose is that their accountants are likely to require them to change so as to allocate the software revenue over future periods due to IFRS 15 because they host the software. This is the same problem that Rolls-Royce have tripped up on, and it is also an issue at Ultra Electronics (ULE) according to a report in the FT yesterday. That company also issued a profit warning on Monday and the share price fell 19.5% on the day. I used to hold it but not of late. The FT writer suggested it was time to “exit”. Cambridge Cognition did suggest though that they would not need to restate last years accounts, and the change might actually smooth their revenue figures. IFRS 15 is an important correction to historic aggressive revenue recognition policies in some companies.

Otherwise Cambridge Cognition have some interesting technology – for example using smart watches to monitor brain function during the day, and using speech recognition to perform analysis. Whether these can be turned into profitable markets remains to be seen. One of the original ideas in the company was to provide their software on i-Pads for general practitioners to use in diagnosis but that never took off due to changes in purchasing arrangements in the NHS who of course are notoriously difficult to sell to (and budgets of late for technology seem to have been cut). If anyone wants more background on Cambridge Cognition you are welcome to contact me.

A few weeks ago I purchased a minute number of shares in Wey Education (WEY). Minute because although it looks an interesting business I thought the share price was way too high on any sensible fundamental view. This morning the company announced a share placing to make an acquistion. This will be at 22p which is a 33.3% discount to the price on the 14th November according to the company. Clearly advisors and institutions took the same view as me on the previous share price. Has the share price collapsed this morning as a result? It’s down but not by much so far. Wey Education does look like one to monitor (which is why I bought a few shares) but I think I’ll stand back from the speculation for the present while the market is so twitchy.

This looks like one of those hot technology stocks that are all the rage of late (the company provides education over the internet as an alternative to school attendance). But investors are clearly getting more nervous about many of those stocks in the last few days – it’s no longer “keep buying on momentum” as some share prices have fallen back from their peaks (Abcam is one example), so it’s now sell, sell, sell. And if a company indicates that the outcome for the year will not be as good as the optimistic broker forecasts suggest, as IDOX did mid-afternoon yesterday, then the share price gets hammered. Announcements mid-afternoon of this nature are never a good idea. Interesting to note that Richard Kellett-Clarke is to remain on the board after all as a non-executive. He was previously CEO. That might inspire more confidence in the business as these kinds of hiccups did not occur during his regime.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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A Quick Guide to New Issues, SMRs, Car Market and Brexit

In today’s Financial Times (11/11/2017) Neil Collins gave a quick guide to new issues which is worth repeating. This is what he said: “Do not buy into an initial public offering if most of the capital raised is going out of the business, or if it replaces existing debt (because the capital has already left). Do not buy if private equity is selling. Do not believe any forward-looking statements, because if the prospects really were that good, the vendors would wait and get a higher price. Do not buy any share that has been listed for less than a year. You will miss some bargains but you will avoid many more disappointments. Leave it to the professionals to lose other people’s money.”

Those are wise words indeed. He also made some ascerbic comments on small nuclear power stations which he says have been rebranded as “small modular reactors” (SMRs) to make them less scary. Rolls-Royce, who have produced such reactors for submarines, have touted them as a potential future business growth area for several years, but the FT’s in-depth review of the subject last week suggested that they are not likely to be put into production any time soon. Meanwhile the share price of Rolls-Royce is still below where it was in 2014.

Neil Collins also commented on the car market. You probably don’t need to be told that new car sales have slumped. The share prices of car dealers are cheap as chips and even my shares in Auto Trader are down substantially this year. Indeed one could apply Neil’s comments about IPOs to the company although it has taken a couple of years to reveal that the debt when listed is handicapping the company now. The car market is inherently cyclical which is one reason why car dealers are normally not valued highly, and they also show low barriers to entry with the car manufacturers controlling the market to a large extent and limiting the profits that dealers make. But Auto Trader is similar to Rightmove in the property market. High margins, dominant market position and a business with great network effects with the result that competitors find it difficult to muscle in on their market. I think I’ll stick with it for a while yet.

I am not convinced that we have reached “peak car” as some have suggested. There seem to be more cars on the road than ever although traffic volumes have slowed in London where most such commentators live. But that is as much about political policies that have limited road space and caused congestion, mostly irrational, than car buyers desires. Another good analysis in the FT recently was about how “green” various car types actually are. On total life emissions, some smaller petrol/diesel vehicles can beat “all-electric” cars. How is that? Because the manufacture and decommissioning of electric vehicles generate large emissions, and producing the electricity for them often does also.

With all these plugs I just gave for the FT, it is unfortunate that it coninues to publish such tosh about Brexit. Most of their writers predict the financial outcome will be calamitous. Whether that will be the outcome or not, I don’t have the space to provide a full analysis here, but most people who voted for Brexit did not consider the financial issue as conclusive. Consider an American colonialist in the year 1775, before their declaration of independance. No doubt with an economy very reliant on trade with Great Britain many people would have counselled against leaving the protection of their parent country. Did that deter them? No because they valued freedom more highly. They wanted control over their own affairs including that over taxes, and not to be ruled by a remote and undemocratic regime where they had minimal representation. That is the analogy that all the remainers should think about.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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National Grid, Johnston Press, Crown Place VCT, Lloyds Bank, LoopUp and Brexit

I had a busy day yesterday, but let me first comment on the news today. National Grid (NG.) published their half year results this morning. They reported “Adjusted operating profit, excluding timing up 4%….” but statutory earnings per share were down by 12%. What exactly does “adjusted for timing” mean? I have no idea because the announcement does not explain it in any sensible way. For example, it says under “UK Timing”: “Revenues will be impacted by timing of recoveries including impacts from prior years”. Why are these revenues not being booked in the relevant period? Why are they not being recognised as revenues in the period concerned? Looks like a simple “fudge” to me as “adjustments” to reported figures in accounts often are. Many analysts seem to have a negative view of the stock, and I am coming to the same conclusion. I sold some of my holding in the company this morning.

I have previously mentioned the requisition of an EGM at Johnston Press (JPR), but the company has rejected this on the basis that it is “not valid”. It seems this is because the shareholder who requested it holds their shares in a nominee account (i.e. are not on the register). Yet another example of the obstruction caused by the use of nominee accounts. Changes to the law in this area are required to fully enfranchise all shareholders. See the ShareSoc Shareholder Rights campaign for more information: https://www.sharesoc.org/campaigns/shareholder-rights-campaign/

Yesterday morning I attended the AGM of Crown Place VCT, managed by Albion Capital. No excitement there. Just a competently managed VCT and a well run AGM with a presentation from one of their investee companies (PayAsUGym) who have developed an innovative business selling gym sessions. Crown Place made a total return of 14% last year and currently provide a tax free dividend yield of 6.9% which is covered twice by earnings. The expense ratio is 2.4% which is certainly better than many of the VCTs I hold. Previously this company had a strong focus on “asset-based” investments but they are now restricted by the new rules for VCTs so they are moving into more “exciting” fields. There are also concerns about further rule changes or removal of tax reliefs in the budget next Wednesday. Investors in tax incentivised vehicles seem to be getting nervous.

After lunch with representatives of AGMInfo, I filled an hour or so before the ShareSoc AGM by dropping into the Lloyds Bank legal action nearby which I have mentioned in previous blog posts. On the witness stand was former CEO of Lloyds TSB Eric Daniels being cross examined by the littigants QC. He gave a confident performance and was clearly well prepared. He said he was “bitterly disappointed” over the need to raise £7 billion in capital and was also disappointed that they would end up more highly capitalised than other banks. It was clear from his other comments that there was a certain momentum to go through with the deal (the acquisition of HBOS) and that they did not revisit the benefits of the transaction at every turn (e.g. as more information came out of the due diligence work for example).

He disclosed that in a conversation with the FSA there were real concerns that they could lose the vote of shareholders. This could be because there were views that HBOS could remain independent, although the Government had already indicated that it was promptly going to be nationalised if no rescue deal could be done; and because Lloyds TSB shareholders might vote against it.

The case continues. Lloyds Bank and the former directors continue to say that the claims have no merit of course.

It was then onto the ShareSoc AGM. Again no great excitement there. Mention was made of a possible merger with UKSA and as a former director of both I spoke in favour of that. Spreading the fixed costs over two organisations of a similar size makes a lot of sense. It should never have been necessary to set up a rival organisation to UKSA, but interesting to note that ShareSoc has more members now so my efforts in recent years were not in vain.

The ShareSoc AGM was followed by one of their company presentation seminars. Of interest to me (being current holders) were the two by LoopUp (LOOP) and Ideagen. I reported on Ideagen recently on coverage of their AGM so will only cover LoopUp herein. The presentation by their joint CEO Steve Flavell was slick but it was more a sales pitch for the product/service to customers than one to investors. The issue of them having two joint CEOs was raised in a question later.

The emphasis was on the simplicity of the service, so anyone could take it up easily and quickly. This is the major USP as there are lots of other conferencing products around. Most interesting was his explanation that they leapfrogged the “chasm” by ignoring the early adopters (who often like techy products) by aiming straight for the “mainstream majority”. His reference to “Crossing the Chasm” is from a book of that name by Geoffrey Moore which is essential reading for all sales/marketing executives in the software field, or investors in early stage technology companies likewise. Just had a chat with an Uber driver about this book – he has a degree in marketing – that’s the modern world for you. It will be a great shame if Sadiq Khan manages to put Uber out of business – might miss out on intelligent conversations with cab drivers. I read the book when it first came out back in the 1990s and Mr Flavell had read it also. I highly recommend the book. LoopUp is clearly a sales/marketing driven organisation but the technology is sophisticated enough to make it all look simple.

On the current valuation, the company has obviously a long way to go to grow into that valuation. Questions were raised about whether growth could be accelerated (revenue only up 39% in 2016m and 44% in the interims this year). But I expressed scepiticsm on attempts at a faster growth rate to Flavell after the meeting.

The Financial Times continue to publish anti-Brexit stories and editorial every day. My letter to the editor on the dubious bias, which they published, has obviously had no impact whatsoever. Tim Martin, CEO of JD Wetherspoon, had a lot to say about the subject of the impact of Brexit on food costs in his latest trading statement. He accused the media, and the Chairman of Sainsburys and that of Whitbread, and the head of the CBI, for completely distorting the facts. Rather than food prices rising after Brexit, he suggests they will fall. For his arguments see:

https://www.investegate.co.uk/wetherspoon–jd–plc–jdw-/rns/fy18-q1-trading-update/201711080700068513V/

My conclusion is quite simply that some foods might become more expensive, others might become cheaper, and home-produced products might also be cheaper; plus the Government might be able to save a lot of money on contributions to subsidising inefficient farmers. But that of course means that food buying habits might change as consumers react to price changes. Is that a bad thing? Readers can ponder that question.

Whether the Chairmen or CEOs of public companies should be making comments on essentially political issues, one way or the other, is also a question to consider. I suggest that might best be left to bloggers like me. Sainsburys and Whitbread (Costa, Premier Inns) might find they disaffect half their customers while having minimal impact on public opinion.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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