Cloudcall Placing, Patisserie News, Brexit and Momentum Investing

I reported a week ago on a “Capital Markets Day” at Cloudcall (CALL) – see https://roliscon.blog/2019/01/18/cloudcall-investor-meeting-sophos-rpi-and-brexit/ . There was much discussion on whether the company should raise more finance, via debt or equity. I suggested they needed more equity. This morning they announced a placing of 2.4 million shares at 100p to raise (the share price last night was 109p. It represents about 10% dilution for other shareholders. The placing was completed in minutes so they had clearly lined up existing investors in advance. The cash will be invested (i.e. spent) on sales and marketing.

But they are also refinancing and extending their debt facility. Let us hope they don’t have to use it.

More bad news from Patisserie (CAKE). A report in the Guardian, based on sight of the information sent to bidders by the administrator, suggests that the accounts were false as far back as 2014. That’s when the IPO on AIM took place. In addition, sales in established stores had fallen by 4% in the last two years and the remaining 122 stores were on course to make a £2 million loss in the year to September 2019.

The Guardian report mentioned a number of possible bidders for some of the outlets, but generally few of them. So the chance of a major realisation for the benefit of creditors in such a “fire sale” process seems unlikely.

Brexit. After last night’s votes in the Commons, the battle lines between Theresa May and the EU look to be drawn up. She is getting near a clear mandate from Parliament which will help in the battle with EU bureaucrats and politicians who are adamant they won’t renegotiate the Withdrawal Agreement. But they will have to if they don’t want the UK to exit without one, which would threaten a lot of EU country exports. Come March 28th, it will be time for a face-saving compromise – no change to the Withdrawal Agreeement – just the addition of a codicil providing alternatives to the Backstop.

Momentum Investing. Are investors falling out of love with Momentum Investing? Momentum investing has been one of the most attractive investing strategies in the last few years. If a share price was going up, you just bought more, regardless of fundamentals. There were many academic studies showing that it was a very effective strategy. In ten years of rising shares prices, it was relatively foolproof. But when share prices are going down, as in the last part of 2018, it does of course work in reverse. You have to sell shares as the prices drop.

Just reviewing a few model portfolios run by investment magazines and on-line portals suggests to me that momentum investing is no longer working as the 5 year and longer returns generated are worse than the market as a whole. The moral is that there are no simple solutions to achieving superior investment returns. Once everyone is aware of a successful strategy, its benefits disappear as they are traded away.

It looks like we will have to revert to the hard work of doing financial and business analysis of companies rather than simply following shooting stars.

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

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Tesco and Barclays Legal Cases; Rent Controls and Telford Homes

A few events transpired last week which I missed commenting on due to spending some days in bed with a high temperature. Here’s a catch-up.

The remaining prosecutions of former Tesco (TSCO) executives for the accounting scandal in 2014 that cost the company £320 million and resulted in the company signing a Deferred Prosecution Agreement (DPA) and paying a big fine has concluded. The defendants were found not guilty. The prosecutions of other executives were previously halted by the judge on the grounds that they had no case to answer. Under the DPA, Tesco were also forced to compensate affected shareholders.

Everyone is asking why Tesco agreed to the DPA, at a cost of £130 million, when it would seem they had a credible defense as no wrongdoing by individuals has been confirmed. The defendants were also highly critical of the prosecution on flimsy evidence that destroyed their health and careers. This looks like another example of how the UK regulatory system is ineffective and too complicated. The only winners seem to be lawyers.

Another case that only got into court last week was against former Barclays (BARC) CEO John Varley and 3 colleagues. This relates to the fund raising by the company back in 2008 – another example of how slow these legal cases progress in the UK. This case is not about illegal financial assistance given to Qatari investors as one might expect, those charges were dropped, but about the failure to disclose commissions paid to those investors as part of the deal and not publicly disclosed. The defendants deny the charges.

Comment: this long-running saga seems to stem from the Government’s annoyance over Barclays avoidance of participation in the refinancing of banks at the time. Lloyds and RBS ended up part-owned by the Government, much to the disadvantage of their shareholders. Barclays shareholders (I was one at the time) were very pleased they managed to avoid the Government interference, precipitated by the Government actually changing the capital ratios required of banks. Barclays were desperate for the Qatari funds of at least one £ billion with one Barclays manager saying “They’ve got us by the balls….”.

Will this case conclude with a conviction, after a few millions of pounds spent on lawyers’ fees? I rather doubt it. And even if a guilty verdict is reached, how severe will be the likely penalty? Bearing in mind that the damage suffered by investors as a result seems minimal, i.e. it’s purely a technical breach of the regulations, it seems both pointless and excessive to pursue it after ten years have elapsed. Again the only winners seem to be lawyers.

One amusing aspect of this case was the grim “mug-shots” of 3 of the defendants attending court that appeared in the Financial Times. It was clearly a cold day and one of them was wearing a beanie hat. Is this the new sartorial style for professional gentlemen? Perhaps so as my doctor turned up wearing one to attend my sick-bed. Clearly I may need to revise by views on what hats to wear and when.

One has to ask: Are the cases of Tesco and Barclays good examples of English justice? Prosecutions after many years since the events took place while the people prosecuted have their lives put on hold, their health damaged and with potentially crippling legal costs. This is surely not the best way of achieving justice for investors. Justice needs to be swift if it is to be an effective deterrent and should enable people to move on with their lives. Complexity of the financial regulations makes high quality justice difficult to achieve. Reform is required to make them simpler, and investigations need to be completed more quickly.

Investors might not have noticed that London Mayor Sadiq Khan is going to include a policy of introducing rent controls in his 2020 election manifesto. Rent controls have never worked to control rents and in the 1950s resulted in “Rackmanism” where tenants were bullied out of controlled properties. It also led to a major decline in private rented housing as landlords’ profits disappeared so they withdrew from the market. That made the housing shortages in the 1960s and 70s much worse. The current housing shortage in London would likely be exacerbated if Sadiq Khan has his way as private landlords would withdraw from the market, leaving tenants still unable to buy although it might depress house prices somewhat.

But the real damage would be on the construction of new “buy-to-let” properties which would fall away. Institutions have been moving into this market in London and construction companies such as Telford Homes (TEF) have been growing their “build-to-rent” business in London.

Sadiq Khan is proposing a policy that he would require Government legislation to implement, which with the current Government he would not get. No doubt he is hoping for a change in that regard. Or is it simply his latest political gambit to get re-elected? In the last election he promised to freeze public transport fares as a vote winner, so he clearly has learnt from that experience. But he’s probably already damaging the private rented sector.

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

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Patisserie – and How to Avoid Disasters

The events at Patisserie (CAKE) have been well covered in both the national media and financial press so I won’t repeat them here. This article will therefore concentrate on how to avoid such companies in the future. The case of Patisserie is very similar to those of Globo in 2015 and Torex Retail in 2007. All three were large AIM companies that went into administration after fraud was discovered. These were not just cases of over-optimistic or misleading financial accounts, but deliberate false accounting. Executives of Torex Retail received jail terms and Globo is still being investigated. Note that such criminal cases take years to come to a conclusion. Both Globo and Patisserie were audited by the same firm (Grant Thornton). Such cases can happen not just in relatively small AIM companies, but also large ones – for example Polly Peck.

Ordinary shareholders received zero from the administration of Torex Retail and Globo and it is very likely it will be the same from Patisserie. The only glimmer of light is that it does look as though a normal sale process is being followed by the administrators and there is at least one enthusiastic bidder for the remaining stores. There is also the prospect of a tax refund from HMRC because it is clear the fraud has been running for some years so Patisserie has been paying tax on imaginary profits. But the bank overdrafts/loans need paying, loans from Luke Johnson need repaying (which incredibly seem to rank ahead of the banks), trade creditors need paying, staff need paying, HMRC needs paying and the administrators will run up the usual enormous bills no doubt so I doubt there will be much, if anything, left after those distributions. There usually is not.

Legal action against the former directors who were culpable in these events by regulatory authorities is highly likely. For example, it is a crime (market abuse) to publish false accounts under the Financial Services and Markets Act so that would be one basis. Investors who invested in the company on the basis of those false accounts should submit a complaint to the Financial Conduct Authority (FCA) and encourage them to take such action.

Are there possible legal actions by investors to recover their losses? Perhaps and I know at least two people who are talking to solicitors about that. But such legal actions are very expensive and depend on a) Identifying defendants with sufficient assets to meet both the claim and legal costs; b) Having sufficient standing to do so. Unfortunately shareholders would probably have to do it via a “derivative action” which means applying to the court to force the administrator to pursue such a claim. Bearing in mind administrations are often relatively short term, and it will take years to conclude regulatory investigations and actions, there might be a problem there.

Who could be targeted? The auditors possibly although they will probably say they were misled by the company directors (bank accounts not disclosed, etc). Luke Johnson perhaps although he clearly denies previous knowledge of the fraud and pursuing him for breach of his responsibilities as a director might be difficult – however he does have the assets having taken well over £20 million out of the company in share sales over the years. Former finance director Chris Marsh sold shares worth £8.42 million in 2018 while former CEO Paul May sold shares worth £14.34 million in that year it is worth noting. They both appear to have been near the centre of the fraud but culpability clearly will need to be proved. They have yet to comment in public on the matter.

Were the share sales by those two executive directors a sign that all was not well at the company? Perhaps but Luke Johnson was not selling in 2018 and these sales were the result of share option exercises from LTIPs which executives often sell, partly to meet tax demands.

So how to avoid such fraudulent companies from damaging your wealth in future? From experience I can offer the following advice, and you will see why Patisserie side-stepped all the warning signs:

  1. Try to invest in directors who you feel you can trust. Luke Johnson had a very public reputation in the investment world which he was no doubt keen to protect. Indeed his actions to try and bail-out the business when the fraud was discovered shows exactly that, although institutional investors who took up the rescue rights issue will be none too happy. His fellow executive directors were a long-established team and hence should have been trustworthy. Make sure you take opportunities to meet the management.
  2. Do the financial analysis. Read the book “The Signs Were There” which I have covered in a previous article – it tells you where to look. For example, do the profits turn into cash? But if the cash on the balance sheet is a lie, as at both Patisserie and Globo, it does not help. Does the company not pay dividends when it could, or make decisions to raise more debt when it does not apparently need it or provide good justification? That was the what crystalised my views on Globo.
  3. Look at who else is investing or commenting on the company, e.g. Chris Boxall of Fundamental Asset Management, a very experienced small cap investor, or Paul Scott of Stockopedia who recently said “Quindell, Globo and Carillion were easy to spot a mile off – indeed we warned investors of all 3 long before they blew up. Patisserie Valerie however, appeared to be a wonderful, cash generative business”. Because I follow what others are saying and pay attention, I never invested in Torex Retail and I did not lose money on Globo despite holding some shares until the end. But Patisserie fooled pretty well everyone.
  4. Research the product or service offering. Some people say they were wary because when they visited the shops, they were not busy and did not like the cakes. That was not my experience after a number of visits to different locations.
  5. Read the IPO prospectus for AIM companies. It tells you a lot more than you can read in the Annual Reports and is legally required under AIM rules to be available on their web site.
  6. Invest in steps and not at the IPO so you can build confidence in the company. Private investors have the advantage of being able to do that. After all it’s unusual for frauds to run for years without being discovered by someone – rarely by auditors though. I first invested in Patisserie in 2017 and built up a small holding in stages following the share price momentum. But this was only limited protection and it appears the fraud had been going on for many years at Patisserie.
  7. Have a diversified portfolio so one company can go bust and it does not undermine your overall returns. If you invest in large cap companies which may be less risky, perhaps 10 to 20 shares are sufficient diversification. Throwing in a few investment trusts or other funds will help as they are intrinsically diversified. But if you are investing in AIM shares you need a lot more. By having a large portfolio of shares in terms of numbers of holdings the damage to my portfolio from the administration has been a loss of 0.9% of my portfolio value. That’s less than the portfolio varies from day to day on some days. I have spoken to a number of investors who bet their houses or life savings on one share, e.g. Northern Rock or the Royal Bank of Scotland rights issue. One at least went bankrupt. Don’t be so daft.
  8. Monitor news flow on a company and unusual share price movements. But at Patisserie there was really nothing unusual until the date the shares were suspended.

I hope the above comments help investors to avoid the dogs and complete frauds of the investment world. Some of these avoidance techniques help you to avoid not just outright frauds but general financial mismanagement by company directors.

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

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Placings at Gordon Dadds and Blue Prism

There were two placings announced yesterday. The first was by legal firm Gordon Dadds (GOR). I held a very few shares in the company. This company had already annoyed me by suspending the listing of the shares for several months while they finalised an acquisition deal. Totally unnecessary. If Northern Rock could remain listed while in their death throws, the propensity to suspend shares simply because there is more uncertainty about the business is not justified. This annoyance also arose at Patisserie (CAKE) recently. Investors can decide for themselves whether they want to hold the shares, and possibly take more risk, or not.

The placing by Gordon Dadds was also annoying. Apart from the dilution of 25%, it was a placing at a price of about 25% below the market price. Needless to say, this was taken up by institutional investors very promptly indeed while, as usual, private investors had no opportunity to do so. There did not seem to be any great urgency in this fund raising as it was simply to provide “financial flexibility” for their acquisition strategy. So why no full rights issue or open offer?

I simply do not wish to hold shares in companies that treat their investors this way. Those that do tend to be repeat offenders. So I sold the shares I held.

Another interesting placing was in Blue Prism (PRSM) a fast-growing supplier of office automation software, which I do not hold. The company also announced their full year results for the year to October. Revenue more than doubled to £55 million, but losses went up in a similar proportion to £26 million. The market cap is now an incredible £939 million (i.e. 17 times sales revenue).

Their placing was aimed at raising £100 million and was got away at 1100p (no significant discount to recent price but way down on a few months back). The purpose of the placing was given as this: “The Group is seeking to capitalise on the market opportunity available by accelerating its investments in distribution, its product and platform whilst maintaining its thought leadership in the RPA market.”

So it’s interesting to compare this approach with the position of Cloudcall (CALL) previously discussed who might expand faster if they raised more funds but are also loss making. Clearly Blue Prism intend to take the US approach and try to grab market leadership in a relatively new and potentially large market, i.e. it’s a land grab. This can work but the risk is that competitors who are more cost efficient can erode market share and often they all end up losing money until reality sinks in. Is what Blue Prism is doing that difficult to replicate by competitors? I do not know enough about their product to judge that but the share price and risk are too high for me.

It’s worth bearing in mind that in the software world you can sell almost anything with a good story if you spend enough. Whether such sales are really profitable can be very difficult to judge when money is also being spent at the same time to expand the business.

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

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RBS Share Buy-Back

The Royal Bank of Scotland (RBS) is proposing to buy-back up to 4.99% of its shares from the stake held by the Government (by UKFI on its behalf). At present the Government holds 62% of the company stemming from the bailout in the banking crisis ten years ago. They have been trying to get shot of it ever since as no Tory government thinks it should be investing in banks. This latest proposal makes it clear that UKFI cannot easily sell the shares in the market, nor place them with institutions, perhaps because there are still outstanding lawsuits faced by the company.

Should shareholders support this proposal? I don’t think so, and I will be voting against it with the few shares I hold which were acquired to support the ShareSoc campaign for the appointment of a Shareholder Committee. Incidentally this proposal rather suggests that it is now even more important to have such a Committee because this proposal may be of advantage to the Government but it is not at all clear whether it is of benefit to shareholders as a whole.

Fortunately UKFI won’t be able to vote their shares at the EGM to approve the proposed buy-back so other shareholders will decide the issue.

Other shareholders might wish to ask themselves, why should shares only be bought back from UKFI and not all shareholders, e.g. via a tender offer. Another negative is that this share buy-back is effectively a reduction in capital when banks like RBS still have a relatively thin equity capital base. In any case, I generally vote against buy-backs other than in investment trusts. They are usually misconceived. The Government commissioned research into share buy-backs a year ago on the grounds that they may be being used to inflate executive pay (reducing the number of shares in issue increases earnings per share which is a common element in executive pay bonus and LTIP schemes). The research has yet to produce a report.

Personally I would like to see share buy-backs made illegal except in very limited circumstances, as they used to be. They are rarely of benefit to other shareholders and can be used by foolish management to try to manage the share price.

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

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Cloudcall Investor Meeting, Sophos, RPI and Brexit

Yesterday I attended a “Capital Markets Day” for Cloudcall (CALL), a company in which I hold a few shares. But not many because it has been one of those technology companies with fast growing revenue but it has been slow in actually reaching profitability. The result has been multiple share placings, the last one in October 2017, to plug the negative cash flow hole. So cash flow was no doubt on investors minds at the meeting, as you will see.

The company sells unified communications technology to businesses using CRM systems. A couple of their major partners are Bullhorn (a recruitment/staffing software business) and Microsoft with their MS Dynamics product and there were speakers from both companies at the meeting. They helped to explain the attractiveness of the product to their customers, which I do not doubt.

CEO Simon Cleaver covered the latest product enhancements which will potentially enable them to integrate with 4 or more new CRM products in 2019. It will also include broadcast SMS messaging and mobile support which their customers need. Apparently there will be an increased focus on the US market, but the company is also looking at the APACS region and Brazil from later comments, where there are obvious opportunities. Pete Linas from Bullhorn made an interesting comment that the company has been missing out on business growth due to lack of finance – suggesting perhaps that a more aggressive strategy be adopted as per early stage US technology companies, i.e. ignore the losses and negative short-term cash flow and raise more finance.

CFO Paul Williams, covered the recent trading statement which was positive. Group revenue up 29% but cash burn was £1.5m in H2 2018, i.e. still consuming cash rather than generating it. Cash available was given as £2.75m. Paul also covered how the growth in users converts into revenue and future profits but they seem to have a relatively high churn rate for this kind of business, i.e. customers dropping out subsequently. It was not made clear why they lose some customers/users and what the customer contract durations actually are. However in response to one of my questions it was stated that forecast revenue growth for this year will be 40% (that’s higher than analyst’s forecasts so far as I can see).

Paul also said cash burn was reducing and Simon said that it was down to £240k per month, with sufficient cash to break even, if the sales numbers are met. He suggested that if more cash was needed (e.g. to fund US expansion) then they could raise their existing debt level from £1.8m to £3.0m and the board would prefer to raise the debt than more equity. The impression was given that conversations around that had already taken place and Paul Scott questioned whether the bankers would want to lend to a loss-making business – it seems they might. Comment: they might but at a hefty cost and with tight mandates. I simply don’t believe that companies like this should be financed via debt. Equity is what is needed for early stage, high-risk technology companies as I said to Simon later. But another placing may not be enthusiastically welcomed by investors at this time.

One interesting comment from the audience questioned whether the company was charging too little for the product. But it appears that they need more functionality to be able to charge more, and that would require more investment of course. But will the company ever become such an essential part of the customers’ business operations that they cannot do without, or even more to the point switch to a competitor? That was not really clear.

Concluding comment: The company is making progress and Simon communicates his enthusiasm well, but I suspect the business will continue to burn cash and financing that with debt makes no sense to me.

Sophos (SOPH) is another technology company that issued a trading statement today. The good news is that it has reached profitability and revenue has increased by 14% year-to-date. The share price promptly dropped by more than 25% in early trading! The reason was no doubt the lackluster growth in “billings” (i.e. invoiced sales) of 2%. Why is that different to the revenue figure? Probably because the revenue includes some accrued from last year on subscription billings. It otherwise looks like it is likely to meet the year-end targets forecasts of analysts. With the share price fall it’s starting to look relatively cheap for a high-growth software business so the key question investors have to ask is whether growth will return? It was no doubt exceptional last year because of IT security scares and new product releases, but is it simply nearing market saturation? An article in Shares magazine has questioned whether the cause of billings slowing is increasing competition from new market entrants so that’s certainly an issue to look at also. There is more explanation of the reasons for billing trends in the audio presentation available here: https://investors.sophos.com/en-us/events-and-presentations.aspx . I have a small holding in Sophos and bought more on the dip today.

RPI concerns. A House of Lords committee has apparently questioned the continuing use of the “discredited” Retail Price Index (RPI) when CPI is a more accurate reflection of inflation. RPI is still used for many purposes, such as rail fare costs, and for index-linked savings certificates and gilts. Personally having just signed up to extend my investment in savings certificates even with minimal real interest on them, I would be most concerned about any change and I would not have done so if the index used changed to CPI which typically gives a much lower figure.

Brexit. Everyone else is giving their views on Brexit so why not me? Here’s some.

Firstly, in case you have not noticed, MPs have apparently been advised that it might take over a year to organise another referendum. So those who are calling for another one are surely misguided. Putting off the EU exit that long, with the uncertainty involved surely makes no sense. And most people are fed up with debating Brexit even if the questions in a new referendum could be decided. Parliament and the executive Government alone need to come up with a solution.

Should we rule out a “no-deal” Brexit? No because it would not be a nightmare as remainers are suggesting. As I was explaining to my wife recently, grapes and bananas might become cheaper because EU tariffs would be removed on food from the rest of the world. What about UK farmers who would face problems in exporting to the EU? Well that just means that beef would also become cheaper in the UK. Secondly to rule out a no-deal Brexit would totally undermine our negotiating position to obtain a good Withdrawal Agreement with the EU. Only the threat of a no-deal Brexit with the risks to exports from the EU to the UK (where of course the trade flow is in their favour at present) will focus the minds of EU politicians. So Jeremy Corbyn’s insistence on ruling out “no-deal” before he will discuss the matter just looks like an attempt to throw a spanner in the works in the hope of getting a general election.

Can Mrs May get enough support for the Withdrawal Agreement as it stands? Undoubtedly not. She has to go back to the EU with proposals for substantial changes to meet the concerns of MPs and the public, e.g. over the Irish “backstop”. If she acts quickly and decisively, I think that could achieve success. If she cannot do so then surely someone else who can provide the required leadership needs to take over – including someone willing to support a no-deal Brexit if required. The current Withdrawal Agreement is not all bad, but contains some significant defects, probably because it appears to have been written by EU bureaucrats rather than as the result of mutual negotiation. It needs revising.

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

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Bogle Death, Patisserie and Diploma AGM

The death of John Bogle has been announced at the age of 89. He wrote several very informative books on investment and was the founder of Vanguard which has grown into one of the largest mutual fund managers by promoting index fund management. He also promoted the idea that the investors should own the fund manager. He suffered from heart attacks from a young age, the first at age 31, and actually had a heart transplant in 1990. So in some respects he was a medical success story as well as an investment one. His books are well worth reading even if you are not a fan of index tracking (I am not).

More bad news from Patisserie (CAKE) with two more non-exec directors resigning and an “update” saying there were thousands of false entries in the accounts. KPMG have been called in to review what to do next and the company’s bankers have been asked to extend the “standstill of its bank facilities”. I suggest investors mentally write off the value of their holdings in this company.

I attended the Annual General Meeting of Diploma (DPLM) yesterday (on the 16th Jan). This is a business that owns a ragbag of technology companies from multiple acquisitions but grew into a financial profile I like to see under the former CEO Bruce Thompson. He led it for 20 years. Consistent growth in profits, good return on capital (about 24%), and good cash flow with rising dividends. Unfortunately, the new CEO they appointed did not work out for some reason and left in August after only a few months. The Chairman, John Nicholas, took over temporarily and they have just appointed a new CEO named Johnny Thomson who was present at the AGM. He used to work for Compass Group which is a much bigger business so I asked him why he joined Diploma. Was he disappointed about not getting the CEOs job at Compass perhaps (the CEO there died in a plane crash)? His answer was that he had spent a long time at Compass and it was time for a change. Was he disappointed? Perhaps, is a summary of what he said.

The company issued a trading statement on the day, which said reported revenues up by 9% in the first quarter, and was otherwise positive. Thank god for such boring companies in these turbulent financial times. I asked a question in the meeting on the possible impact of Brexit and US/China trade wars. The answer was in essence not much so long as US tariffs don’t rise much further (they do import much from China to their US operations).

A poorly attended AGM but useful nevertheless from a company that keeps a low profile.

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

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