Avoiding Another NMC Debacle

Yesterday the shares in NMC Health (NMC) were suspended and a formal investigation by the FCA was announced. The suspension announcement said that the company has requested the suspension of its shares and that the company is focused on providing additional clarity to the market as to its financial position.

The events at NMC are hardly the kind of thing one expects from a FTSE-100 company with reported revenue of $2.5 billion and profits of $320 million. The company operates hospitals and other healthcare facilities in the Middle East – hardly a sector that should be particularly volatile. The company has of course been the subject of an attack by Muddy Waters and the share price was already down by 80% from their peak in 2018, before they were suspended.

There now seems to be considerable doubts about the accounts (the finance director is on long-term sick leave which is never a good sign), there are doubts about who holds the shares, and questions about related party transactions and debt. The founder and CEO have departed from the board leaving the COO as interim CEO.

I recall NMC being tipped in numerous publications before all this bad news came out and it certainly looked a good proposition at a glance. Both revenue and profits were rising at 30% per year driven by rising wealth in the Arab states. So why did I avoid it?

The key point I would make is that “financial numbers are not important when picking shares” which is the subtitle of my book “Business Perspective Investing”. The numbers alone cannot be trusted even if they have been audited by a big firm such as Ernst & Young.

The company is registered in London and listed in the UK but the company had a peculiar governance structure with two joint Chairman and an Executive Vice-Chairman. They had a large number of directors otherwise and at the last AGM actually approved a resolution to increase the maximum number to 14. That is way too large for any company and results in board meetings being dysfunctional. The Muddy Waters financial analysis clearly raised some concerns and it is well worth reading. It also raised issues about the level of remuneration of the board and share sales. These might be considered warning signs and there is the key issue that it might be very difficult for UK based investors to monitor the operations of the company.

These are the kind of issues that I suggested investors need to look at in my book.

What do investors do if they find they have been suckered into a company with dubious accounts and when other negative facts have come to light? The simple answer is to study the evidence carefully and if in doubt sell the shares. It is never too late to sell is phrase to remember. You only have to look at the share price graph of NMC to see that investors with a trailing stop-loss of 20% would have exited long ago and hence avoided the worse outcome.

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

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Competition in the Audit Market

I attended a “roundtable” event at the Financial Reporting Council (FRC) on Monday. It was primarily a discussion of audit market competition and how to improve it, with private investors attending. But as I said at the meeting the key issues in the audit market are the quality of audits and the accountability of auditors. Too many blatant frauds go undetected by auditors, and they avoid any responsibility for their errors. Being able to avoid accountability for their failings has resulted in declining audit standards over the last few decades. The Caparo legal judgement is one big reason as it prevents shareholders suing auditors for their failings. It needs overturning.

These thoughts were echoed by other speakers at the meeting although the FRC made clear that their focus is on quality.

The Kingman review of the FRC was critical of the audit sector and its regulation by the FRC while the Competition and Markets Authority (CMA) is undertaking a review of the market for audit services which is dominated by the big four audit firms.

Would improved competition for audit services improve the quality of auditing is one key question? Or simply lead to a race to the bottom as price competition was increased? Alternatively could quality be improved by improving the work of audit committees and how they select auditors? All of these questions were discussed but no specific conclusions reached.

One proposal to improve competition is to enforce “joint” or “shared” audits where all audits of larger companies would require the involvement of more than one audit firm. This might enable smaller audit firms to become more experienced and more credible to take on larger audits it is argued. But as I said in my response to the CMA consultation: “ So far as investors are concerned, joint and several liability would be a positive advantage to ensure audit quality in theory. But in practice as auditors avoid liability for most failings, it might not matter a great deal”.

I do not see how joint or shared auditing will improve the quality of audits or necessarily improve competition either. An alternative suggestion that there should simply be a cap on the market share of any one audit firm seems a better and simpler solution to the competition issue.

Apparently according to a report in the FT, audit firms have been lobbying hard to retain the status quo. The FT reported the comments of Will Hayter, a director of the CMA that those in the industry should not doubt the CMA’s resolve to go “from four to more” [audit firms].

Improving competition is undoubtedly of benefit even if it just avoids the risk of one of the big four collapsing (as happened with major audit firm Andersen a few years ago after reputational damage and criminal charges over the Enron fraud). But shareholders major concern is improving the quality of audits so that fraud is detected and dubious financial reports are not published; in other words to ensure that published accounts do indeed contain a “true and fair” view of the financial position of a company.

One example of where they might not be was mentioned in the meeting which is the accounts of Burford Capital (BUR) which I have also commented on myself negatively recently, much to the displeasure of Burford holders. All Burford shareholders should read the article by John Dizard published in the FT on the 17th February and entitled “Burford faces long wait over $1bn Argentina claim”. It questioned the valuation of the Petersen legal claim. See https://www.ft.com/content/6debcc05-e368-44b2-bb99-618b7bc0a618 . The key issue is reliance on the management to value the legal claims where any cash arising from the claimed profits based on the valuation of on-going claims may be a long time in coming, if at all.

In summary we need to improve the accounting and auditing standards if investors are to rely on the published accounts of companies. In the meantime investors will need to take a more sceptical view of the accounts of companies and not take them at face value.

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

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Population Growth Problem, Trump at Davos and More Bad News at Ted Baker

 

7.7 Billion and Growing. That was the subtitle of a BBC TV Horizon programme last night on population. Chris Packham was the presenter. He said the world’s population was 5 million 10,000 years ago but by 2050 it is forecast to be 10 billion. He showed the impact of excessive population on biodiversity and on rubbish generation with lots of other negative impacts on the environment. It is surely one of the most important things to think about at present, and will have major economic impacts if not tackled.

The big growth is coming in countries such as Brazil and Nigeria. Sao Paolo is now 5 times the size of London and it’s running out of water. So are many other major cities including London. The growth in population is being driven by better healthcare, people living longer but mainly via procreation. A stable population requires 2.1 babies per family, but it is currently 2.4. In Nigeria it’s 5!

In some countries it is lower than that. It’s 1.7 in the UK (but population is growing from immigration) and it’s 1.4 in Japan where an ageing population is creating social and economic problems.

The FT ran an editorial on the 14th of January suggesting population in Europe needed to be boosted but it received a good rebuke in a letter published today from Lord Hodgson. He said “Global warming comes about as a result of human activity, and the more humans the more activity.  This is before counting the additional costs of the destruction of the natural world and the depletion of the world’s resources. In these circumstances suggesting there is a need for more people seems irresponsible”.

I completely agree with Lord Hodgson and the concerns of Chris Packham. The latter is a patron of a campaigning charity to restrain the growth in population called Population Matters (see  https://populationmatters.org/ ). Making a donation or becoming a member might assist.

For a slightly different view in Davos President Trump made a speech decrying the alarmist climate views and saying “This is a time for optimism, to reject the perennial prophets of doom and their predictions of the apocalypse”. He was followed by a 17-year old with limited education who said just that and got more coverage in some of the media. I believe Trump and moderate environmental writers like Matt Ridley who suggest we can handle rises in world temperature and that the future is still rosy. But we surely do need to tackle the problem of a growing world population.

Chris Packham reported how this was done somewhat too aggressively in India and China but there are other ways to do it via education and financial incentives. Just ensuring enough economic growth in poorer countries will ensure population growth is minimised. Let’s get on with it!

On a more mundane matter, I have previously commented on the audit failure at Ted Baker (TED). The latest bad news today after an independent review it has been discovered that the inventory problem is twice as worse than previously reported. The company now states that inventory in January 2019 was overstated by £58 million. The share price has fallen by another 7% at the time of writing.

This is not just another example of a minor audit failure. Stock value in the Jan 2019 Annual Report was given as £225 million so that is a 22% shortfall. Auditors are supposed to check the stock and its valuation so this is a major error. It will reinforce the complaints of many investors that audit quality in the UK is simply not good enough and the Financial Reporting Council (FRC ) has been doing a rather inept job in regulating and supervising auditors. But will we see the proposed replacement by ARGA anytime soon, which will require some legislation? It seems this is not a high Government priority at present.

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

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Speedy Hire and Burford Capital

There are a couple of interesting articles in this week’s Investors Chronicle. One of their share tips for 2020 is Speedy Hire (SDY) which I own some shares in after attending a presentation by the company at a ShareSoc meeting in October. I was somewhat impressed by the apparent turnaround in the business that the management has achieved. You can read a write-up of the presentation here: https://roliscon.blog/2019/10/04/speedy-hire-presentation-burford-analysis-and-treatt-trading-statement/

Another very good article in Investors Chronicle was on the subject of fair-value accounting. It should be essential reading for all Burford Capital (BUR) investors. It explains how Enron used mark-to-market accounting to value long-term contracts. Their reported profits surged as they recognised future profits but the cash did not appear so the management then went from creative accounting to downright fraud by the use of off-balance sheet vehicles.

In reality it was using “mark-to-estimate” accounting as there were no public markets for the assets that could provide a sound valuation. How is this relevant to Burford? That company is in the same position in that the majority of its profits come from fair value gains on the value of the legal cases it is pursuing. As in Enron, the cash flows are very different to the reported profits. In 2018 the reported operating profit was $344 million but the cash outflow was $198 million.

As I said in my blog article mentioned above, I have always been doubtful about the merits of the company and one reason is the answer to the question “Do profits turn into cash?” The answer is “Not in the short term at Burford”. They are effectively recognising what they consider to be the likely chance of success in current profits. But winning legal claims is always in essence uncertain. I have been involved in several big cases and your lawyer always tells you that you have a very good chance of winning as they wish to collect their fees, but even if you win collecting any award can be uncertain”. In essence the accounts of Burford rely to a large extent on management’s estimates of the chance of winning cases and hence the future profits.

Incidentally a few respondents to my mention of my portfolio performance last year in a previous blog post and tweet requested details of my portfolio holdings and investment strategy. My response was that I don’t like disclosing the details mainly because listing all my holdings and providing reasons for them would be tedious but clearly one reason for success is avoiding companies such as Burford where profits do not turn into cash. As regards my investment strategy this is well covered in my book Business Perspective Investing https://www.roliscon.com/business-perspective-investing.html.

As I point out in the book, attending presentations by management or attending Annual General Meetings can give you useful information and the ShareSoc events are very relevant to that objective so I recommend them.

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