Category: Economics

AssetCo, Patisserie, Stockpiling, Warehouses, Sheds, Brexit and Venezuala

A week ago, an award of damages of £21 million plus interest and costs was made against Grant Thornton for their breach of duty when acting as auditors of AssetCo Plc (ASTO) in 2009/10. See https://www.bailii.org/ew/cases/EWHC/Comm/2019/150.html for the full judgement. I understand Grant Thornton may appeal. These are the key sentences in the judgement: “It is common ground that in those years the senior management team at AssetCo behaved in a way that was fundamentally dishonest. During the audit process management made dishonest statements to GT, provided GT with fabricated and massaged evidence and dishonestly misstated reported profits, and provided GT with flawed and dishonest forecasts and cash flow projections. Outside of the audit process, management were engaged in dishonestly ‘overfunding’ assets (i.e. misleading banks as to the costs of new purchases etc so as to borrow more than was permitted), misappropriating monies, dishonestly under-reporting tax liabilities to HMRC, concluding fraudulent related party transactions and forging and backdating documents. GT accepts that it was negligent in a number of respects as the company’s auditor in failing to detect these matters…”

In 2012, AssetCo (ASTO) was forced to make prior period adjustments for 2010 that wiped more than £235m off its balance sheet. AssetCo was, and still is, an AIM listed company now operating in the fire and emergency services sector.

This is undoubtedly a similar case to Patisserie (CAKE). According to a report by Investors Champion, former Chairman Luke Johnson suggests it “has possible relevance for a claim against Grant Thornton” and he will be pushing the administrators to instigate similar action. Let us hope it does not take as long at ten years and millions of pounds in legal costs which administrators may be reluctant to stand.

According to a report in the FT, manufacturers are stockpiling goods at a record rate in anticipation of supply chain disruption from Brexit. Importers are also stockpiling goods – for example Unilever is storing ice-creams and deodorant such as its Magnum ice-cream bars which are made in Germany and Italy. There is also the increasing demand for warehousing by internet retailers, even for smaller “sheds” to enable them to provide next day or even same day delivery.

Big warehouses are one of the few commercial property sectors that has shown a good return of late and I am already stacked up with two of the leaders in that sector – Segro (SCRO) and Tritax Big Box (BBOX). On the 31st January the Daily Telegraph tipped smaller company Urban Logistics REIT (SHED) for similar reasons and the share price promptly jumped by 7% the next day wiping out the discount to NAV.

There has been much misinformation spread about Nissan’s decision to cancel manufacture of a new car model in the UK. They denied it was anything to do with Brexit. This was to be a diesel-powered model and as they pointed out, sales of diesel vehicles are rapidly declining in the UK. The same problem has also hit JLR (Jaguar-LandRover). One aspect not taken into account in many media stories was that Japan has just concluded a free trade deal with the EU. Japanese car manufacturers no long need to build cars in Europe to avoid punitive tariffs. Where will the new vehicle now be made? Japan of course!

There has been lots of media coverage of the politics of Venezuela and its rampant inflation. A good example of how damaging extreme socialism can be to an economy. Over twenty-five years ago it had a sound economy and I had a business trip scheduled to visit our local distributor there. But at the last minute the trip was cancelled after a number of people were killed in riots over bus fares. I never did make it and I doubt I will ever get there now.

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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IC Share Tips, National Grid, Brexit and the Audit Market

This week’s Investors Chronicle edition (dated 28/12/2018) provides lots of food for thought. One of the most educational is their review of the share tips they published as “tips of the week” in 2018. Unlike some investment publications, who simply forget about their past tips that go nowhere, while lauding their hits, the IC is open about their performance.

They issued 173 “BUY” tips and 24 “SELL” tips in the year. That is quite some achievement by itself as I rarely have more than a very few good new investment ideas in any one year and tend to hold most of my investments from year to year.

How did their tips perform? Overall the “BUYs” returned minus 11.5% which they calculate as being 0.9% better on average than the relevant index. Hardly worth the trouble of investing in them bearing in mind the need to monitor such individual share investments and the transaction costs. The “SELLs” did better at -18.0% versus an index return of -8.8%.

The BUYs were depressed by some real howlers. Such as tipping Conviviality shortly before it went into administration, although they did reverse that tip to a “SELL” before it did so. The result was only a reported 12% loss. As a consequence they are making some “fundamental changes to the way we recommend shares”.

But with so many share tips, the overall performance was not impacted by one or two failures and tended to approximate to the overall market performance. Which tells us that you cannot achieve significant over or under performance in a portfolio by holding hundreds of shares.

I don’t work out my overall portfolio performance for the year until after it ends on the 31st December so I may report on it thereafter. That’s if it’s not too embarrassing. With many small cap technology stocks in my portfolio, I suspect it won’t be good. I always look at my individual gains and losses on shares at the year end, as an educational process. As Chris Dillow said in the IC, “Investing like all our dealings with the real world, should be a learning experience: we must ask what we got wrong, what we got right, and what we can learn. The end of the year is as good a time as any for a round up…”.

One BUY tip they made was National Grid (NG.) in May 2018 on which they lost 11.8%. There is a separate article in this week’s IC edition on that company which makes for interesting reading as a former holder of the stock. I sold most of my holding in 2017 and the remainder in early 2018 – that was probably wise as you can see from the chart below (courtesy of Stockopedia).

National Grid Share Price Chart

National Grid has a partial monopoly on energy distribution and always seemed to be a well-managed business. Many investors purchase the shares for the dividend yield which is currently about 6%. But the IC article pointed out that proposals from OFGEM (their regulator) might limit allowed return on equity to 3%, which surely threatens the dividend in the long term. The share price fell 7% on the day that OFGEM announced their proposals. Bearing in mind the risks of running an electricity network, and the general business risks they face, that proposed return on equity seems to be completely inadequate to me. That’s even if one ignores the threat of nationalisation under a possible Labour Government.

Another IC article in the same edition was entitled “Brexit and the UK Economy”. That was an interesting analysis of the UK economy using various charts and tables. One particularly table worth studying was the balance of trade between the UK and our main trading partners. We have a big negative balance (i.e. import more than we export) to Germany, Spain, Belgium, Holland and Italy but positive balances with Ireland and the Rest of the World – particularly the USA. The article makes clear that our trade with EU countries has been declining – exports down from 55% in 1999 to 44% of all exports. But imports have not fallen as much so the trade gap has been widening. Meanwhile our exports to Latin America and China, which have been good economic growth areas, have remained relatively small.

The conclusions are simple. EU economies such as Germany would be severely hit by any trade disruption on Brexit. But opportunities in rapidly growing markets are currently being missed, perhaps hampered by inability to negotiate our own trade deals with them, and that might improve after Brexit.

Audit Market Review

The Competition and Markets Authority (CMA) have published an “Update Paper” on their review of the audit market. It contains specific recommendations on changes to improve competition and asks for comments. See https://assets.publishing.service.gov.uk/media/5c17cf2ae5274a4664fa777b/Audit_update_paper_S.pdf .

It mentions a long list of audit failings on pages 12 onwards including banks before the financial crisis of 2008, BHS, Carillion, Autonomy (covered in a previous blog post) and Conviviality which was mentioned above.

This paragraph in their executive summary is worth repeating: “Independent audits should ensure that company information can be trusted; they provide a service which is essential to shareholders and also serves the wider public interest. But recent events have brought back to the surface longstanding concerns that audits all too often fall short. And in a market where trust and confidence are crucial, even the perception that information cannot be trusted is a problem.”

One problem they identify is that “companies select and pay their own auditors” which they consider an impediment to high-quality audits. In addition choice is exceedingly limited for large FTSE companies, with the “big four” audit firms dominating that market.

Their proposals to improve matters are 1) More regulatory scrutiny of auditor appointment and management; 2) Breaking down barriers to challenger firms and mandatory joint audits; 3) A split between audit and advisory business within audit firms and 4) Peer reviews of audits.

Their review of FRC enforcement findings suggests that the most frequent findings of misconduct include:

(a) failure to exercise sufficient professional scepticism or to challenge management (most cases);

(b) failure to obtain sufficient appropriate audit evidence (most cases); and

(c) loss of independence (three out of a total of 11 cases).

That surely indicates a major problem with audit quality, and that is backed up by the FRC’s own analysis of audits that they have reviewed with only 73% being rated as “good or requiring limited improvement”.

Auditors are primarily selected via audit committees and there is a noticeable lack of engagement by shareholders in their selection. But that’s surely because large institutional shareholders have little ability to judge the merits of different audit firms.

Would more competition improve audit quality, or simply cause a focus on the lowest price tenders? The report does not provide any specific comment on that issue but clearly they believe more competition might assist. More competition does appear to drive more quality for a given expenditure in most markets however so it is surely sensible to support their recommendations in that regard. The report does emphasise that the selection and oversight of auditors would ensure that competition is focused on quality more than price which is surely the key issue.

A previous proposal was that auditors be appointed by an independent body but that has been dropped, partly due to shareholder opposition. The new proposal is for audit committees to report to a regulator with a representative even sitting as an observer on audit committees where justified. In essence it is proposing much more external scrutiny of audit committee activities in FTSE-350 companies and decisions taken by them.

The end result, at some cost no doubt, would be that both auditors and audit committees will be continually looking over their shoulders at what their regulators might think about their work. That might certainly improve audit quality so for that reason I suggest this proposal should be supported.

The requirement for “joint” audits where two audit firms including one smaller firm had to be engaged seemed to be opposed by many audit committee chairmen and by the big four accounting firms. Some of their objections seem well founded, but the riposte in the report is that evidence from France, where joint audits are compulsory, suggests they have a positive impact on audit quality. Moreover, it would clearly increase competition in the audit market.

In summary, the report does appear to provide some sound recommendations that might improve audit quality. But investors do need to respond to the consultation questions in the report as it would seem likely that the big audit firms will oppose many of them.

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

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Market Trends, Interest Rates, and Yu Group Accounts

Yesterday was another dismal day in the markets. The US fell significantly allegedly caused by the rise in interest rates announced by the Federal Reserve and the UK market followed it down this morning. The US rate rise was widely expected although perhaps slightly lower estimates for US economic growth had an impact. But when the markets are in a bear mood, excuses for selling abound. Meanwhile the Bank of England has announced today that their base rate will remain at 0.75%. The UK market recovered somewhat after it’s early fall, even before that announcement at 12.00 am. Did it leak one wonders, or is it those city high fliers with big bonuses stimulating the market before it closes for Xmas? Or was it the news from GlaxoSmithKline (GSK) that a de-merger was to take place? Many market trends are unexplainable so I won’t say any more on that subject.

The general state of markets was highlighted in a recent press release from the Association of Investment Companies (AIC). They represent investment trusts and reported that the industry’s assets hit an all-time high of £189 billion in September but pulled back subsequently. At the end of November the average investment company returned 1.3% over the prior year they said, but that suggests that when the year ends most will be lucky to show any return at all. Investors who manage to beat zero for 2018 should consider themselves either lucky or wise.

But the good news the AIC reported was that many investment trusts, 37 of them, have reduced fees in 2018. Even better news was that 9 of them abolished performance fees which I believe is a good move for investors. There is no evidence that performance fees improve investment managers’ performance and they just lead to higher fees. Needless to point out that the lack of returns in 2018 might have encouraged the trend to cut performance fees!

Not only that but the average return of 1.3% by investment companies beat that of the average of open funds who showed a loss of 2.6% and the FTSE All-Share with a loss of 6%. Perhaps this is because there are more specialist or stock-picking investment trusts as opposed to the many open-ended index trackers and heavy weighting in a few large cap dominated sectors in the FTSE. That shows the merits of investment trusts (I hold a number but very few open-ended funds).

Coming up to Xmas and the New Year, it’s worth warning investors about share trading in small cap stocks and investment trusts though. Both often have low liquidity and this is exacerbated over the holiday season as active investors take a break. The result is that such stocks can spike or decline on just a few trades. Might be a good time to take a holiday from following the markets even for us enthusiastic trend followers.

Yu Group (YU.) is the latest AIM company to report fictitious financial accounts. Yu Group is a utility supplier to businesses and only listed on AIM in March 2016, reached a share price peak of 1345p in March 2018 and is now 68p at the time of writing, i.e down 95% – ouch!

An announcement by the company yesterday, following a “forensic investigation” of its past accounts, reported more bad news including serious deficiencies in the finance function. They are now forecasting an adjusted loss before tax of between £7.35 million and £7.85 million for the year ending December 2018, but that excludes lots of exceptional costs including possible restatement of prior year accounts. Future cash flow is also called into question. In summary it’s yet another dire tale of incompetent if not downright fraudulent management in AIM companies which it seems likely the auditors did not spot. The FCA and FRC should be investigating events at this company with urgency. The AIM Regulatory and NOMAD system has also again failed to stop a listing or what clearly has turned out to be a real dog of a business.

Let us hope that the mooted changes to financial regulation in the UK bear some fruit to stop these kinds of disasters in future years. Risks of business strategy failures and general management incompetence we accept as investors. Likewise general economic trends, even Brexit risks, and investor emotions driving markets to extremes we accept as risks. But we should not need to accept basic accounting failures.

On that note, let me wish all my readers a Happy Christmas and a prosperous New Year.

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

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Budget Summary – Austerity Coming to an End

Philip Hammond’s budget today can be summarised as:

  • More money for the NHS.
  • More money for the MOD.
  • Money for schools.
  • More money to fix potholes.
  • More money for housing.
  • More money for the Universal Credit scheme.

Yes “austerity” is being relaxed. Changes to taxation are relatively minor, but there will be a new tax on “digital platforms” which is clearly aimed at large companies such as Facebook and Alphabet (Google) who generate large revenues from their operations in the UK but pay very little tax on the resulting profits. There will also be a new tax on plastic packaging (comment: that could have been tougher if the problem of plastic pollution is to be tackled). These new taxes may be at relatively low rates initially but once a new tax regime is in place, the rates tend to go up if history is any guide.

Fuel duty is frozen, beer and cider duty are frozen, spirits duty is frozen but wine duty will rise to match the increase in the cost of living. Tobacco duty will rise also.

There will be a new Railcard for the 26-30 age group to help the millenials.

Personal income tax allowances will rise in April 2019 – £50,000 for higher rate taxpayers. And capital gains tax allowance will rise to £12,000.

All the suggestions about changes to pension tax relief, inheritance tax and AIM tax advantages seem to have been ignored, so there is little to dislike about this budget for stock market investors.

In summary a confident performance from Mr Hammond with an avoidance of unnecessary changes to taxation which helps with longer term planning.

More information available from the Treasury here: https://www.gov.uk/government/news/budget-2018-24-things-you-need-to-know

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

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Which Way Is The Market Headed?

Whenever one meets with other investors of late, a question they ask is “”Which way do you think the market is headed?”. One of my sons also asked me that question and I said to him that I had no real clue, although it might continue in the same direction. I give my reasons in this article.

The weekend papers are full of explanations of the recent market declines, and prognostications about the future, by experienced financial journalists. This was no doubt at the behest of their editors who understand that readers are looking for simple answers. When the markets are in rout, the key thoughts of investors are likely to be should I sell, to protect my portfolio value by moving into cash, or should I buy now that shares are becoming cheaper and possible bargains appearing?

FTSE Chart

Having been through more than one boom and bust in my investing career (chart of the FTSE All-Share in that period above showing percentage change in capital value from 1997), I only make predictions about the market in extremis, i.e. when it looks ridiculously expensive or ridiculously cheap. You can see that so far there has only been a minor correction in the last few weeks. Incidentally that chart shows that the FTSE All-Share is up about 70% in that period while my own portfolio is actually up 270% which I track in a similar way.

Some of the influences that are currently being talked about are the trade wars between the USA and other countries, the impact of Brexit, the ending of QE and higher interest rates, the view that shares had become too expensive, and general despondency. When markets are in decline, all news tends to be treated as bad news. So when the US economy is reported as continuing to grow strongly, this is viewed as negative as it means higher interest rates will come in sooner.

The fact of the matter is that markets are driven by expectations and emotions as much as hard facts. It is undoubtedly true that most investors portfolios are showing very healthy returns in the last few years so everyone is holding on to large profits. That is still true even after the carnage of the last few weeks. But just reading a few tweets issued by investors tells you that many are now showing a loss on the year to date. This makes them nervous.

It’s also true that the long, uninterrupted bull run has pulled many people into stock market investment who think it might be an easy way to make money when cash earns little on deposit and the housing or buy-to-let markets are no longer attractive.

There is one truism though. Once markets start moving in a certain direction, then they tend to continue in the same direction, driven by emotion. Just as share prices of individual companies show high short-term correlation, so do share prices in general. They can both be driven by “momentum” traders now that everyone knows that momentum is a key aspect of successful investment strategies.

Just considering the UK market, where most of my readers are probably invested, it’s also true that UK market trends are dictated by US market trends and other international markets over night. What happens in the morning on trading days in the UK tends to follow what happened in the USA the previous day/night. It’s always worth keeping an eye on the S&P 500 to check that – see this web site for a useful chart of a daily view (or longer periods): https://www.bbc.co.uk/news/topics/c4dldd02yp3t/sp-500

Will that tell you which way the UK market is headed? Only in the sense that trends tend to persist, until they reverse and are driven by international dynamics. Trying to guess which way it’s headed is a waste of time, and effort.

As a result, some folks take the stance that they’ll hold their portfolios unchanged through thick and thin. If you are an institutional investor, where you are paid to invest client’s money in shares, not in cash and your earnings depend on portfolio value commissions, you may not have much choice. But private investors do.

My view is that trying to be contrarian in market declines makes no sense except in extremis. Following the trend is sensible, until there are obvious highs and lows where reversals might take place. So I sell on the way down, and buy on the way up, while trying not to over-trade (i.e. not react to short term moves which tend to be expensive in terms of spreads and broking charges). I also take into account the nature of the stocks and any capital gains tax liabilities that might result, i.e. I will sell those showing a loss or hold those where tax would be incurred. That also means I prefer to sell those in my ISAs and SIPPs where tax consequences can be ignored. The current market is also a good time to rationalise my portfolio which has too many stocks in it and is overdiversified.

In relation to the nature of the stocks, those hardest hit by any general market decline are those that are small and speculative so they are the first to go. In a market rout everyone starts looking at whether the company is making real profits, generating cash and paying dividends in the short term, not to a sunlit horizon in the future.

That’s not to say that I have suddenly fallen out of love with growth stocks. But there is good growth and there are speculations. Companies that have good technology, good business models, and are generating good returns on capital are still the ones I like to own. The recent figures from Amazon and Alphabet (Google) were seen as negative because the growth in sales and profits appeared to be slowing – but they are still growing at a very brisk rate in comparison with old economy stocks. They are both now very big companies so at some point growth was likely to slow, but there are many smaller technology companies who can achieve great growth rates irrespective of the overall state of the economy.

At this point I do not see that we are near a turning point, but neither do I try to predict one. Shares look neither ridiculously expensive or ridiculously cheap unlike say back in 2008 for example when doom and gloom pervaded everywhere. There is no good reason to pile back into bonds with short term interest rates still low and the UK and US economies looking healthy.

To track the trend while managing cash I follow a simple rule – if my overall portfolio falls by £10,000 I sell £10,000 worth of shares and put the resulting cash on deposit. That way assuming you have an unleveraged portfolio you can never go bust. If my portfolio and the market start to rise, I’ll move the cash back into shares.

In summary, I am following market trends and in the meantime am just looking to hold good quality companies and buying more where there are suitable buying opportunities, while disposing of the dogs. I don’t try to bet against market trends.

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

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Frying in Hell and Investing in Oil Companies

Last night and this morning, the national media were dominated by the news from the Intergovernmental Panel on Climate Change that we are all going to fry in a rapidly rising world temperature unless we change our ways. CO2 emissions continue to rise and even to limit temperature rises to 1.5 degrees Celsius requires unprecedented changes to many aspects of our lives.

The suggested solutions are changes to transport to cut emissions, e.g. electric cars, eating less meat, growing more trees, ceasing the use of gas for heating and other major revolutions in the way we live.

So one question for investors is should we divest ourselves of holdings in fossil fuel companies? Not many UK investors hold shares in coal mines – the best time to invest in coal was in the 18th and 19th century. That industry is undoubtedly in decline in many countries although some like China have seen increased coal production where it is still financially competitive. See https://ourworldindata.org/fossil-fuels for some data on trends.

But I thought I would take a look at a couple of the world’s largest oil companies – BP and Shell. How have they been doing of late? Looking at the last 5 years financial figures and taking an average of the Return on Assets reported by Stockopedia, the figures are 2.86% per annum for Shell and 0.06% per annum for BP – the latter being hit by the Gulf oil spill disaster of course. They bounce up and down over the years based on the price of oil, but are these figures ones that would encourage you to purchase shares in these businesses? The answer is surely no.

The figures are the result of oil exploration and production becoming more difficult, and in the case of BP, having to take more risks to exploit difficult to access reserves. It does not seem to me that those trends are likely to change.

Even if politicians ignore the call to cut CO2 emissions, which I suspect they will ultimately not do, for investors there are surely better propositions to look at. Even electric cars look more attractive as investments although buying shares in Tesla might be a tricky one, even if buying their cars might be justified. Personally, I prefer to invest in companies that generate a return on capital of more than 15% per annum, so I won’t be investing in oil companies anytime soon.

But one aspect that totally baffles me about the global warming scare is why the scientists and politicians ignore the underlying issue. Namely that there are too many people emitting too much air pollution. The level of CO2 and other atmospheric emissions are directly related to the number of people in this world. More people generate more demand for travel, consume more food, require more heating and lighting and require more infrastructure to house them (construction generates a lot of emissions alone). But there are no calls to cut population or even reduce its growth. Why does everyone shy away from this simple solution to the problem?

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

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Royal Bank of Scotland on BBC2

Some readers may have watched the BBC2 programme on Tuesday about the collapse of the Royal Bank of Scotland (RBS). It showed the hubris of Fred Goodwin – suites at the Ritz, private jets and a new headquarters opened by the Queen in which he had an enormous office. But when I posted a brief comment on the Stockopedia blog to the effect that the bail out had political overtones, it got some criticism. Indeed to my mind the programme seemed to suggest that Alistair Darling and Mervyn King were heroes who rescued the bank, and the country, from financial disaster and there was no contrary opinion on the merits of what they did.

So here’s some more explanation of the problems of RBS and how they should have been tackled.

RBS certainly was acting aggressively before the crash in 2008. It had one of the lowest capital asset ratios of any bank and then proceeded to acquire ABN-AMRO after competing with Barclays in a bidding war. RBS seemed to expect the profits from ABN-AMRO to improve its cash flow. Although it’s not easy to see the cash flows in banks, they can run out of cash particularly when loans they have borrowed become due for repayment.

One needs to understand that all banks operate on a knife edge – they have massive liabilities backed by massive assets, with only a thin slice of shareholders equity in the middle. So you will find in the December 2008 balance sheet of RBS that it had assets of £2,401,652 million, liabilities of £2,321,154 million and shareholders’ equity of only £80,498 million.

When the financial crisis arose as a result of the realisation that the US sub-prime mortgage market was heading for a fall, liquidity in the bank loan market disappeared. That is what caused the crash at Northern Rock – see: https://roliscon.blog/2017/09/02/northern-rock-10-years-after-collapse/ for past comments on that. Northern Rock was not balance sheet insolvent which would have triggered administration, it was cash flow insolvent. It just ran out of cash because folks were withdrawing cash from the bank and it could not refinance the short-term loans it had taken out in the money markets. Similar problems caused the collapse of Lehman Bros and Bradford & Bingley and the former had world-wide repercussions. The whole world was suffering a banking liquidity crisis.

There were of course subsequent steps taken to tighten up on the bank asset ratios which meant they had to raise more capital. That put many banks into an even more difficult situation. There also was a growing realisation that many banks had assets on their balance sheet that were questionable in value, i.e. debts might not be repaid but they had not been written down because of defective accounting standards (see more in today’s FT on that subject).

In addition the UK Government made the mistake of nationalising Northern Rock and Bradford & Bingley which told any international investor of equity, or even debt, into UK banks that they had no real security. The Government could prejudice their investment using the new legislation that was introduced, at the drop of a hat.

As the BBC programme described, there came a day when RBS had to tell the Governor of the Bank of England that they would run out of cash in a few hours. The collapse of RBS would certainly have undermined the whole UK banking system with other banks also crashing as they had outstanding loans to RBS. The Government’s answer was to launch a massive “recapitalisation” of RBS and other banks via forcing then to sell equity stakes in return for cash. They were given no option but to accept overnight. This effectively meant a nationalisation of RBS because they acquired control of it, along with major stakes in other banks.

Was there a different way they could have taken? Banks frequently run out of cash because of the narrow equity they hold. They can go for years without a hiccup, paying out good returns to shareholders in the meantime, until minor events disrupt this idyll. But the Bank of England can always provide loans to relieve the cash flow pressure if nobody else will. The Bank can of course effectively print money if necessary to do that. RBS did of course undertake a massive rights issue (the largest ever) to strengthen its balance sheet but that was not sufficient. Could they have got by with funding from the Bank of England when the crunch came? I suggest they might. I suggest the prime reason for the approach that was taken was the desire of the Labour Government (headed by Gordon Brown and Alistair Darling) to take control of the banking sector.

In reality other countries tackled their similar problems in different ways. But the UK was the most severely hit by the financial crisis. It was of course not just RBS that had exposure to US sub-prime mortgages. Other major world banks had similar difficulties. But the approach taken in the UK destroyed confidence in the UK financial sector in very short order.

That does not of course make any excuse for the mismanagement of RBS by Fred Goodwin and the general incompetence of the board of RBS in the critical period. But it is all too easy to lay the blame for the UK banking crisis on one individual – it’s called “personification”. But there were no heroes either.

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

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The Impact on Investors of the Labour Party’s Plans

I commented briefly yesterday on the plans by John McDonnell of the Labour Party to give employees shares and possible future nationalisations – see: https://roliscon.blog/2018/09/24/labours-plans-for-confiscation-of-shares-and-rail-system-renationalisation/

More information is now available on the share scheme and the more one studies it the more one realises that whoever devised it does not understand much about business and the stock market. In other words they were typical politicians with no experience of the real world I would guess.

The scheme would apparently operate by companies with more than 250 employees being forced to hand over 10% of the shares in a company to an employee trust fund. That would be over a period of time – possibly ten years – and presumably that would be by the issuance of new shares rather than confiscating existing shares, but it still means 10% dilution for investors.

Shareholders normally get a vote on the issuance of new shares but presumably that could be legally subverted. Otherwise the scheme would cover about 11 million employees. However, foreign owned companies would not be covered so that excludes perhaps a third of the employees (the Labour Party apparently admits they would not be and it is difficult to see how legally any such law could be enforced on them).

One simple way for companies to avoid the scheme would be to move their country of registration elsewhere – no need to change where their shares are listed, just move domicile. We could see a host of companies re-registering in such places as Panama! An unintended consequence that I am sure the Labour Party would not like.

The shares accumulated in the trust fund would pay dividends to the individual shareholders out of the dividends paid to the fund by the company. But there would be a cap of £500 per employee. Any amount payable above that cap would revert to the Government. It is estimated this might generate £2 billion a year to the Government after 5 years – another large tax hike in addition to proposed increases in Corporation Tax the Shadow Chancellor is promising.

Employees could not buy or sell the shares held on their behalf, so presumably could not take them away when they leave or retire. So in practice those companies with high staff turnover would see the dividends accumulating for the benefit of the Government, particularly if the £500 cap remain fixed, i.e. unindexed.

But the company could avoid paying out this windfall to the Government simply by not paying dividends. Many companies don’t pay dividends anyway. Alternatively they could pay a dividend in shares (a “scrip” dividend), or offer to buy back shares occasionally via a tender offer or market share buy-backs– these would not be dividends and hence would be excluded.

Another problem with the scheme is that companies who had a few less than 250 employees could decide not to expand and hence become subject to this scheme, i.e. this would discourage companies from growing which is not what the Government wants. Alternatively they could create new separate companies owned by the same shareholders to expand their business and avoid it that way.

Apart from the 10% dilution that will hit not just direct investors but those investing via pension schemes, you can see that this scheme is not just daft because of its unintended consequences and likely avoidance, it’s an insidious way to raise taxes on companies and investors very substantially.

The only good aspect of the scheme is that it would help to give employees a stake (albeit indirect) and hence interest in the company they work for. It might also ensure some representation of their interests because the trust fund would be controlled by employees and could vote the shares. But there are much better ways to provide both those benefits.

In conclusion, the idea of an employee trust fund sounds attractive at first glance but it has not been properly thought through. A lot more consideration needs to be given to come up with a workable scheme that does not prejudice companies and their investors. Any foreign investor who saw such a scheme being imposed on his UK investment holdings would promptly run a mile – and don’t forget that most of the UK stock market is now owned by foreign investors. The impact on the Uk stock market, and the economic consequences of investors taking their businesses and investment money elsewhere beggars belief.

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

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Lehman Collapse, Labour’s Employment Plans, Audit Reform Ideas and Oxford Biomedica

There was a highly amusing article in today’s FT by their journalist John Gapper explaining how he caused the financial crisis in 2008 by encouraging Hank Paulson, US Treasury Secretary, to resist the temptation to rescue Lehman Brothers. So now we know the culprit. Even more amusing was the report on the previous day that the administrators (PWC) of the UK subsidiary of Lehman expect to be left with a surplus of £5 billion. All the creditors are being paid in full.

Why did Lehman UK go bust then? They simply ran out of cash, i.e. they were cash flow insolvent at the time and could not settle payments of £3bn due on the day after their US parent collapsed. Just like Northern Rock where the assets were always more than the liabilities as also has been subsequently proven to be the case.

Perhaps it’s less amusing to some of the creditors of Lehman UK because many sold their claims at very large discounts to third parties rather than wait. Those that held on have been paid not just their debts but interest as well. So the moral is “don’t panic”.

Lehman’s administration is in some ways similar to the recent Beaufort case. Both done under special administration rules and requiring court hearings to sort out the mess. PWC were administrators for both and for Lehman’s are likely to collect fees of £1billion while employing 500 staff on the project. It may yet take another 10 ten years to finally wind up. Extraordinary events and extraordinary sums of money involved.

An editorial in the FT today supported reform of employment legislation as advocated by Labour’s John McDonnell recently. He proposed tackling the insecurity of the gig economy by giving normal employment rights to workers. I must say I agree with the FT editor and Mr McDonnell in that I consider that workers do have some rights that should be protected and the pendulum has swung too far towards a laissez-faire environment. This plays into the hands of socialists and those who wish to cause social unrest. Even the Archbishop of Canterbury suggested the gig economy was a “reincarnation of an ancient evil” and that it meant many companies don’t pay a living wage so employees rely on state welfare payments. A flexible workforce may give the country and some companies a competitive advantage but it takes away the security and dignity of employment if taken to extremes. The Conservative Government needs to tackle this problem if they wish to be certain of getting re-elected. If you have views on this debate, please add your comments to this blog.

Mr McDonnell also promoted the idea of paying a proportion of a company’s profits to employees – effectively giving them a share in the dividends paid out. That may be more controversial, particularly among shareholders. But I do not see that is daft either so long as it is not taken to extremes. After all some companies have done that already. For example I believe Boots the Chemists paid staff a bonus out of profits even when a public company.

Another revolutionary idea came from audit firm Grant Thornton. They suggest audit contracts should be awarded by a public body rather than by companies. This they propose would improve audit standards and potentially break the hold of the big four audit firms. I can see a few practical problems with this. What happens if companies don’t judge the quality of the work adequate. Could they veto reappointment for next year? Will companies be happy to pay the fees when they have no control over them. I don’t think nationalisation of the audit profession is a good idea in essence and there are better solutions to the recent audit problems that we have seen. But one Grant Thornton suggestion is worth taking up – namely that auditors should not be able to bid for advisory or consultancy work at the same company to which they provide audit services.

Oxford Biomedica (OXB) issued their interim results this morning (I hold the stock). They made a profit of £11.9 million on an EBITDA basis. OXB are in the gene/cell therapy market. What interests me is that there are some companies in that market, at the real cutting edge of biotechnology with revolutionary treatments for many diseases, that are suddenly making money or are about to do so. That’s often after years of losses. Horizon Discovery (HZD) which I also hold is another example. Investors Chronicle recently did a survey of similar such companies if you wish to research these businesses. It is clear that the long-hailed potential of cell and gene therapy is finally coming to fruition. I look forward with anticipation to having all my defective genes fixed but I suspect there will be other priorities in the short term particularly as the treatments can be enormously expensive at present.

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

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