JESC and WPCT – Much in Common

Last week I received the Annual Report of JP Morgan European Smaller Companies Trust (JESC) which I have held since 2012. It has a good long-term performance but last year was disappointing. Net asset value return of minus 7.5% which is worse than their benchmark of minus 3.6%. The share price did even worse and it is now on a discount to NAV of nearly 15% as the discount has widened. The under-performance was attributed to poor stock selection.

The Chairman, Carolan Dobson, is stepping down at the AGM this year after nine years’ service. I did not support her re-election last year as I thought she had too many jobs. She is also the Chair of The Brunner Investment Trust plc, Baillie Gifford UK Growth plc , BlackRock Latin American Investment Trust plc and a director of Woodford Patient Capital Trust (WPCT). You have probably been reading much about the latter of later given Neil Woodford’s difficulties.

The Annual Report of JESC says “The Trust’s excellent longer-term performance remains intact” which is a very questionable statement. JESC is an actively managed fund and the manager says “The investment process is driven by bottom-up stock selection with a focus on identifying market leading growth companies with a catalyst for outperformance”, i.e. it’s a stock picking model like the Woodford funds.

Last year that clearly has not worked. Perhaps it is because of a new focus on environmental, social and governance factors (ESG) which has been “rigorously integrated into their investment process”. They have also been “selectively adding cyclical companies back into the portfolio where valuations have become attractive”.

I will be unable to attend the AGM on the 10th July but I think shareholders who do need to question whether this is another stock-picking manager who has lost his touch like Woodford.

On WPCT there was an interesting article today (Saturday 15/6/2019) on Industrial Heat, an unlisted company which is the biggest holding in the fund. The company is valued at almost $1 billion after a new round of fund raising. The company is focused on cold fusion which nobody has yet proved to be a viable technology and the FT article is somewhat of a hatchet job on the business. It all looks exceedingly dubious and I could not find any detailed review of the technology that the company is claiming or much information on the company at all.

I think the boards of both WPCT and JESC need to start asking some tough questions of their fund managers. Such as “convince me why these companies in the portfolio are good investments?”.

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

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PwC Fined over Audit at Redcentric

Audit firm PwC have been fined £4.5 million by the Financial Reporting Council (FRC) for the defective audits of Redcentric (RCN) in 2015/2016. Two audit partners at the firm were also fined £140,000 each.

Redcentric is an IT services company which had to restate its accounts when a £20 million hole was discovered. Assets were written down and the profit of £5.3 million in 2016 was restated to be a loss of £4.2 million. Professional scepticism by the auditors was apparently missing so that management were able to present fictitious figures and get them through the audits.

The current Chairman of Redcentric appears to be reluctant to pursue legal action on behalf of shareholders against PwC which is surely unfortunate. Shareholders would have difficulty in pursuing an action for their losses directly because of the Caparo legal judgement, but a “Derivative” action can be pursued I suggest.

But this is yet another case where the audit profession has failed to pick up serious defects in the accounts of a company. It’s yet another example of why the audit profession needs to improve its game to meet the reasonable needs of investors and other stakeholders.

I have never held shares in this company but I feel for those who were duped by the company and its management into investing in it.

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

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Paying Illegal Dividends, Burford Capital, Woodford Patient Capital Trust and Zero Carbon Objective

A group of investors including Sarasin, Legal & General, Hermes and the UK Shareholders Association (UKSA) has written to Sir Donald Brydon who is undertaking a review of the audit market. They have yet again raised the question of whether the International Financial Accounting Standards (IFRS) are consistent with UK company law. In particular they question whether profits are sometimes being recognised, thus allowing the payment of illegal dividends. The particular issue is whether profits can arise on certain transactions under IFRS from transactions between parent and subsidiary companies or by the use of “mark to market” accounting. The problem is “unrealised profits” that might turn into cash in the future, but may not.

This may appear a somewhat technical question, but it can in practice lead to over-optimistic reporting of profits, leading to excessive bonus payments to managers, and the general misleading of investors. Actually calculating when a dividend can be paid as dividends are not supposed to be paid out of capital is not easy and is not self-evident to investors. The published accounts do not make it obvious. Regular mistakes are made by companies requiring later “whitewash” resolutions to be passed by shareholders. The ICAEW has previously rejected complaints on this issue but it is surely an area that requires more examination.

Incidentally I was reading a book yesterday entitled “White Collar Crime in Modern England” (from 1845-1929) which is most enlightening on common frauds that arose when limited companies became popular – many of the frauds still persist. In the “railway mania” of the 1840s it was common to set up companies and raise the capital to build a railway when the chance of it operating profitably was low. To keep the share price high, and the directors in jobs, dividends were paid out of capital. To quote from the book: “unscrupulous directors could easily pay dividends out of capital undetected – projecting a false image of profitability and enticing further investment in their lines”. That was an era when auditors did not have to be accountants and were often simply the directors’ cronies. Standards and regulations have improved since then, but there are still problems in this area that need solving.

There was an interesting discussion on Twitter recently on Burford Capital (BUR) with regard to their accounting methods. Not that I am an expert on the company as I do not hold shares in it, it but as I understand it they recognise the likely future settlements from the litigation funding cases they take on. In other words, they estimate future cash flows based on projections of likely winning the case and the possible settlements. As I said on Twitter, lawyers will often tell you a case is winnable but they will also tell you the outcome of any legal case is uncertain.

It’s interesting to read what Burford say in their Annual Report under accounting policies where it spells it out: “Owing to the illiquid nature of these investments, the assessment of fair valuation is highly subjective and requires a number of significant and complex judgements to be made by management. The exit value will be determined for each investment by the contractual entitlement, the underlying risk profile of the litigation, a trial or an appellate outcome or other case events, any other agreements in respect of settlement discussions or negotiations as well as the credit risk associated with the investment value and any relevant secondary market activity”.

The auditors no doubt scrutinise the reasonableness of the estimates but any outside investor in the shares of the company will have great difficulty in doing so.

Neil Woodford’s Equity Income Fund has a big holding in Burford Capital. I commented on the Woodford Patient Capital Trust yesterday here: https://roliscon.blog/2019/06/11/woodford-patient-capital-trust-is-it-an-opportunity/ and suggested the Trust made a mistake in naming the Trust after him. It makes it more difficult to fire the manager for example. But the FT reported this morning that the Trust has indeed had conversations about doing just that. Woodford’s firm has a contract that only requires 3 months’ notice which is a good thing. At least they can keep the “Patient Capital” moniker because investors in this trust have already had to wait a long time for much return and it could take even longer to improve its performance under a new manager. But as Lex in the FT said, “patience is now in short supply” so far as investors are concerned.

Another major item of news yesterday was soon to be ex-Prime Minister May’s commitment to enshrine in law a target for net zero carbon emissions in the UK by 2050. This is surely a quite suicidal path for the UK to follow when most other major countries, including all the big polluters, will be very unlikely to follow suit. Even Chancellor Philip Hammond has said it will cost about £1 trillion. It will effectively make the UK completely uncompetitive in many products with production and jobs shifting to other countries. We might become the first really “de-industrialised” country which is not a lead that many will follow, and it will actually be practically very difficult to achieve if you bother to study what is required to achieve zero emissions. It will completely change the way we live with the transport network being a particular problem (trains, planes and road vehicles).

As I have said before, if we really want to cut air pollution and CO2 emissions, then we need to reduce the population as well as rely on such wheezes as electrification of the transport and energy systems. Mrs May’s last act as Prime Minister might be to commit the UK to economic suicide. It might not be a good time to invest in UK manufacturing companies.

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

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Woodford Patient Capital Trust – Is it an Opportunity?

Neil Woodford’s problems at his Equity Income Fund which have caused the fund to close to redemptions have been filling up the pages of the financial press in the last few days. The fact that his reputation is now in tatters has spread like a contagion to others including to Hargreaves Lansdown (HL.) as they effectively recommended the fund (HL. share price is down 22% since May 16). It’s also affected the share prices of holdings in the fund portfolio as investors anticipate that he will have to dump some of his holdings in a fire sale to meet redemptions when the fund reopens.

Another company that has suffered is Woodford Patient Capital Trust (WPCT) which is an investment trust managed by the Woodford firm. It’s down 29% since mid-May and now trades at a discount to net asset value of 27% according to the AIC. That’s quite unusual for any investment trust who can typically control the discount by share buy-backs and other means. The shares are even being shorted by speculators according to a report in the FT which is again unusual for an investment trust. Is this a speculative buying opportunity I wondered? So I took a quick look at the company, and have read the last Annual Report (to December 2018).

This is an unusual trust in many ways. The company has an objective to deliver “a return in excess of 10 per cent per annum over the longer term”. That statement is a hostage to fortune if I ever saw one. It achieved a 6.9% increase in NAV last year, but is down over the last 3 years overall.

It has a peculiar management fee with a low base cost of 0.2% but a performance fee where the manager gets 15% of any excess returns over a 10% cumulative hurdle rate per annum, subject to a high watermark. That’s the kind of management fee that would put me off investing normally.

This is an interesting summary of the trust in the Annual Report: “WPCT has a unique portfolio of companies, developed over a long period, where the Portfolio Manager has a deep insight into the evolution of the businesses. Many of these companies are now in the commercialisation phase. For example, Proton Partners, the UK’s first high-energy proton beam therapy provider, treated 25 patients in its Cancer Centre in Newport last year and opened two further centres in Northumberland and Reading. Autolus successfully listed on NASDAQ and its CAR-T cell technology is in a strong position to drive advances in the battle against cancer. Meanwhile, one of the Company’s largest holdings, Industrial Heat, raised capital from external investors having shown positive progress and it is anticipating reaching a key milestone in the year ahead. Companies within the portfolio are also attracting high-calibre individuals, typified by the senior appointments at Immunocore.”

The trust consists of a portfolio of smaller companies, mainly unlisted but with some listed with a heavy emphasis on healthcare, financials and technology. The largest holdings given on the latest data sheet are Benevolent AI, Oxford Nanopore, Autolus, Atom Bank, Proton Partners, Industrial Heat, Immunocore A, Oxford Sciences Innovation, Industrial Heat A1 Pref and Mission Therapeutics. You only have to look at a few of these to realise that even where listed, the valuations might be problematic, and for unlisted ones that’s even more so. These are early stage companies in most cases.

It’s rather like a VCT portfolio except with even bigger bets on the longer-term prospects of the companies. Lots of comments about positive prospects, increasing promise and making operational milestones in the reviews in the Annual Report but little mention of profits. Page 19 tells you that 65% of the portfolio is unquoted, with 80% classed as “early stage” companies. The trust also employs gearing of up to 20%.

The Board of Directors looks experienced but they are also the typical “great and good” of the investment world, including one Dame, with lots of jobs – too many perhaps.

The trust issued a reassuring statement for investors yesterday. It said “The Board is pleased with the operational progress of its portfolio companies, which the Board believes continue to have the potential to deliver attractive returns, in line with the long-term mandate of the Company. The operational performance of these businesses is not impacted by recent events”. But it acknowledged the impact of events at the Woodford Equity Income Fund and on the share prices of investee companies.

I could spend days analysing the companies in the trust’s portfolio to see whether the valuations made any sense, and still be not much wiser about their real prospects. I am not sure it’s worth the effort. Does the trust have enough cash to undertake any large tender offer or share buy-back is probably more relevant and also meet the needs for more investment typically required by early stage companies? I doubt it.

Regrettably I think the name of Woodford on the trust could cause it to continue to trade at a deep discount even though there is clearly a team of people running the portfolio. It is never a good idea for a fund or trust to name themselves after the fund manager or his company, even if that was a major selling point when first launched.

Trust shares are always tradeable, at least unless a company asks for its shares to be suspended because of doubts about its finances. But the share price discount is driven by investor sentiment and I don’t think the view of this company among investors is going to be very positive for some time.

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

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Broker Charges, Proven VCT Performance Fee and LoopUp Seminar

The Share Centre are the latest stockbroker to increase their fees. Monthly fee for an ISA account is going up by 4.2% to £5.00 per month with increases on ordinary share accounts and SIPPs also. This is the latest of a number of fee increases among stockbrokers and retail investor platforms. The Share Centre blame the required investment in technology development and “an increasing burden of financial regulation”. The latter is undoubtedly the result of such regulations as MIFID II imposed by the EU which has proven to be of minimal benefit to investors. As I was explaining to my sister over the weekend, this is one reason why I voted to leave the EU – their financial regulations are often misconceived and often aimed at solving problems we never had in the UK.

I received the Annual Report of Proven VCT (PVN) this morning – a Venture Capital Trust. Total return to shareholders was 10.3% last year, but the fund manager did even better. Of the overall profits of the company of £18.6 million, they received £7.7 million in management fees (i.e. they received 41% of the profits this year). That includes £5.6 million in performance fees.

Studying the management fee (base 2.0%) and the performance fee, I find the latter particularly incomprehensible. I will therefore be attending the AGM on the 3rd July to ask some pointed questions and I would encourage other shareholders to do the same. I am likely to vote against all the directors at this company.

I also received an Annual Report for Proven Growth & Income VCT (PGOO) and note that of the 4 directors, 2 have served more than 9 years and one is employed by the fund manager. So that’s three out of four that cannot be considered “independent” so I have voted against them. I would attend their AGM on the same day but the time is 9.30 which is not a good choice and would waste a whole day.

Yesterday I attended the “Capital Markets Day” of LoopUp (LOOP). This is an AIM listed company whose primary product is an audio conference call service. It’s just a “better mousetrap” to quote Ralph Waldo Emerson as 68% of the world are still using simple dial-in services rather than more sophisticated software products such as Zoom and WebEx. There are lots of other competitors in this field including Microsoft’s Skype which I find an appallingly bad product from past experience. Reliability and simplicity of use is key and LoopUp claimed to have solved this with no learning required, no software downloads or other complexities and high-quality calls aimed at the corporate market.

I have seen the company present before and do hold a few shares. This event was again a very professional sales pitch for the company and its product with no financial information provided. Yesterday they also covered the addition of video to their basic conference call service which was announced on the day, plus a new service for managed events/meetings. Video addition is probably an essential competitive advantage that was previously missing. They covered how their service is differentiated from the main competitors which was good to understand.

Last year they acquired a company called MeetingZone which has increased their customer base and revenue substantially and are transitioning the customers to the LoopUp product. Revenue doubled last year and is forecast to rise by about 50% in the current year. Needless to say the company is rated highly on conventional financial metrics and return on capital has been depressed by the cost of the acquisition. But one reason I like this company is that it’s very easy to understand what they do and what the “USP” is that they are promoting, plus their competitive position (many company presentations omit any discussion of competitors).

They also have an exceedingly good sales operation based on groups of people organised in “pods” which was covered in depth in the presentation. These only have team bonuses and the key apparently is to recruit “empathetic” people rather than “individualists”. Perhaps that is one reason 60% of them are female. As I said to their joint CEO, I wish I had seen their presentation some 30 or more years ago when I had some responsibility for a software sales function.

The latter part of this 3-hour event was an explanation of how the software/service is used by major international law firm Clifford Chance with some glowing comments on the company from one of their managers. Customer references always help to sell services.

In conclusion a useful meeting, but lack of financial information was an omission although “Capital Market” days are sometimes like that. But the positive was that they had both institutional investors and private investors whereas some companies deliberately discourage the latter from attending such events which I find most objectionable.

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

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Woodford Equity Income Fund Suspension – Analysis and Solutions

The business media is awash with analysis and comment on the closure of the Woodford Equity Income Fund to redemptions – meaning investors cannot take their money out, much to their dismay. I write as an innocent bystander as I have never held any of the Woodford managed funds.

But I have not been totally unaffected by the problem of investors taking their money out, which has led to the suspension, because it has resulted in Woodford needing to sell some of the fund holdings. One of the few companies in his portfolio I hold, and have done for a long time, is Paypoint (PAY). The share price of that company fell in the last 2 days probably because Woodford has been selling it – about 1% of the company yesterday for example reported in an RNS announcement. Paypoint share price has been rising recently so this looks like a case of selling a winner rather than a loser, which is never a good investment strategy.

Standing back and looking at the Woodford Equity Income Fund, even its name seems quite inappropriate. Income funds tend to be stacked up with high dividend paying, defensive stocks. But many of the holdings in the portfolio look very speculative and many pay no dividends. These are the top ten holdings last reported:

Barratt Developments (7.5%), Burford Capital (5.8%), Taylor Wimpey (5.4%), Provident Financial (4.8%), Theravance Biopharma (4.7%), Benevolent AI (4.5%), IP Group (3.3%), Autolus (3.1%), Countryside Properties (3.1%) and Oxford Nanopore (2.6%). Other holdings are Kier (recent profit warning dropped the share price by 40%), NewRiver Reit (I sold it from my portfolio in early 2018 as I could not see how it could avoid the fall out on the High Street), Purplebricks (a speculation which I held briefly but concluded it was unlikely to succeed and was grossly overvalued) and Imperial Brands (a bet on a product which kills people). He is also stacked up with house building companies and estate agents – a sector that many people have exited from including me as house prices look unsustainable with the threat of higher interest rates. However you look at it, the Woodford portfolio is contrarian in the extreme. It even includes some unlisted companies which are totally illiquid and not good holdings for an open-ended fund where investor redemptions force share sales.

The last time big funds closed to redemptions were in the property sector where owning buildings in a downturn showed that the structure of open-funded funds was simply inappropriate for certain types of holdings. Much better to have those in an investment trust where fund investor sales do not force portfolio sales on the manager.

Note that another reason I prefer Investment Trusts to Open-Ended Funds is that they have independent directors who can, and do occasionally, fire the fund manager if things are obviously going wrong.

Part of the problem has been that despite the poor performance of the Woodford Equity Income Fund over the last 3 years (minus 17% versus plus 23% for the IA UK All Companies Index, and ranked 248 out of 248!), platforms such as Hargreaves Lansdown and wealth advisors were still promoting the fund based on Woodford’s historic reputation at Invesco. So investors have been sucked in, or stayed in on the promise of the fund’s investment bets coming good in due course.

What should be done about the problem now? That’s undoubtedly the key concern for investors in the fund. Even if the fund re-opens to redemptions, folks will still want out because they will have lost confidence in Woodford as a fund manager.

It has been suggested in the media that investors might be pacified if fund management fees were waived for a period of time. But that’s just a token gesture to my mind.

I would suggest some other alternatives: 1) That Neil Woodford appoint someone else to manage the fund – either an external fund management firm or a new fund management team and leader. Neil Woodford needs to withdraw from acting as fund manager and preferably remove his name from the fund; 2) Alternatively that a fund wind-up is announced in a planned manner; 3) Or a takeover/merger with another fund be organised – but that would not be easy as the current portfolio is not one that anyone else would want.

One difficulty though is that with such large funds (and it’s still relatively large even after having shrunk considerably), changing the direction and holdings in the fund takes time. So there is unlikely to be any short-term pain relief for investors. Smaller investors should probably get out as soon as they can, but the big institutional investors may not find it so easy.

If readers have any other solutions, please comment.

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

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GoGompare AGM and a Generous Remuneration Scheme

Yesterday I attended the Annual General Meeting of GoCompare.com Group (GOCO) which was actually renamed GoCo Group at the meeting. This was held in the City of London at 3.00 pm but even so there were still very few ordinary shareholders present – less than ten I would guess.

The company’s main business is a price comparison web service, particularly focused on car insurance, but also covering utilities and other products. It is of course fronted by Italian opera singer Gio Compario in TV advertisements. They also have a “Rewards” business providing discount vouchers which they recently acquired and a new business called WeFlip that automates utility switching. The company is chaired by Sir Peter Wood, founder of Esure and Directline insurance companies and he recently purchased about 4% of the business.

Sir Peter introduced the board and then invited questions. I was the only shareholder who asked any questions and I focused on the remuneration. For some background it’s worth noting that the CEO, Matthew Crummock, received a total (single figure) remuneration of £1.59 million in 2018. This is for a company that had revenue of £152 million and pre-tax profits of £33.8 million last year. For 2019 his basic pay will be increased by 12.5% to £450,000 and his maximum opportunity on an LTIP from 200% of salary to 230%. He also gets an annual bonus and “PSP” awards. A typically very complex scheme which results in a 19-page Remuneration Report!

I asked why awards under the “Foundation” bonus scheme were made when the performance targets were not met. It was stated that they were only £1 million short on revenue so the remuneration committee decided to award the bonus and the board supported it.

I also asked about the non-specific Bonus and PSP targets for 2019 given on page 57. What were the “Selection of people and cultural measures” and the “Customer centric measures”? At this point the Chairman suggested that these questions be handled after the meeting but I insisted they should be answered then which he conceded. Some reasonable answers were then given. But I advised the Chairman that I would be voting against the Remuneration Report as I considered it too generous.

Voting was then taken on a poll. But the Chairman advised there were substantial votes against the Remuneration Report on the proxy counts. In fact there were 25% of votes against the Remuneration Report and 15% of votes against Angela Seymour-Jackson who chairs the Remuneration Committee. There were also 11% of votes against Non-Exec Zillah Byng-Thorne perhaps because she is also CEO of Future Plc and also a non-exec at Paddy Power Betfair – too many jobs I suggest.

I spoke to Angela Seymour-Jackson after the formal meeting. She said she was disappointed that institutional shareholders voted against the Remuneration Report. She mentioned the payment of a bonus when the performance target was not met was one reason. I said a bonus target is a target that should be met, otherwise the bonus should not be paid. There will likely be more consultation with investors.

I also explained that I dislike LTIPs because they have been one reason why executive pay has ratcheted up in the last few years, and I particularly dislike those that pay out more than 100% of salary. I told her that bonus schemes need to pay out quickly if they are to provide real incentives, i.e. within months not years. She said they were constrained by the guidance in the Corporate Governance Code. Comment: in fact the latest version of the code does not mandate LTIPs and in any case the Code is always a “comply or explain” system. Companies can adopt better systems if they choose to do so and explain why.

This company is a typical example of why executive pay is out of hand and there is no sign that the directors of such companies are likely to change their ways. The widespread public concern over excessive pay and over-complex remuneration schemes that might pay out very large sums has not yet resulted in any change of policy and remuneration committees are still a soft touch. Change is needed.

Otherwise this was a poor quality meeting – no trading statement issued on the day, no presentation, and minimal shareholder attendance. But I did pick up from talking to one of the directors that the WeFlip business, in which the company is investing millions this year, is ahead of internal targets. But the company will win no prizes for its corporate governance.

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

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