CAKE (Patisserie), Foresight 4 VCT AGM, Payment Companies and Dunelm

More bad news from Patisserie Holdings (CAKE) today – well at least you can’t say the directors are not keeping you informed about their dire situation which is not always the case in such circumstances.

Yesterday the company announced that its major operating company had received a winding-up petition from HMRC, of which the directors had only recently become aware. Today the company said after further investigation the board has reached the conclusion that without an “immediate injection of capital, the Directors are of the view that there is no scope for the business to continue trading in its current form”.

The directors could possibly try to do a quick placing at a deep discount no doubt, borrow a pile of cash at extortionate rates or they could put it into administration. The big risk is that Exec Chairman Luke Johnson will put it through a pre-pack administration. I hope he does not because that won’t do his reputation any good at all. He needs to try and engineer some sensible solution if his reputation in the financial world is to remain intact. That is particularly so after he wrote an article for the Times in September on “a beginner’s guide to tried and tested swindles” suggesting how you can spot them. Clearly he was not taking his own advice. Whatever happens, the outlook for existing shareholders does not look good.

As another commentator said, the Treasury should not reduce the generous tax reliefs on AIM companies because they need to realise that it is a risky market.

But there was some good news on cake yesterday when the Supreme Court decided after all in an appeal from the lower courts that a cakemaker can refuse to bake cakes where the proposed wording in the icing is objectionable to them. A victory for common sense and liberty.

Today I attended the Annual General Meeting of Foresight 4 VCT (FTF). There is one advantage to owning VCT shares. They barely move when the stock market is otherwise in panic mode. They are one of the few “counter-cyclical” investments to public companies as they invest in private equity. There are some disadvantages of course. Illiquidity in the shares, and often disappointing long-term performance as in Foresight 4. But it may be improving.

I won’t cover the meeting in detail but there were a couple of interesting items in fund manager Russell Healey’s presentation. He mentioned they are still having problems with long delays on HMRC pre-approval of new qualifying investments – can still delay deals for a few months it seems. More representations are being made on this.

He also covered the performance of their top few investments. Datapath, the largest, was valued down because EBITDA fell but revenue is still growing and the fall in profits arose from more product development costs. Ixaris, the second largest, is growing strongly (I knew this because I have a direct holding in it and had just read the December 2017 accounts they filed at Companies House). From my recollection that’s the first year they have made a profit since founding 16 years ago. Russell couldn’t remember how many funding rounds the company had launched – was it 6 or 7, and me neither. That’s venture capital in early stage companies for you – you have to be very patient.

However, in response to a question from VCT shareholder Tim Grattan it was disclosed that VISA are tightening up on the rules regarding pre-payment cards. This might affect a significant part of Ixaris’s business. I suspect it will also affect many other pre-payment card offerings by payment companies, some of whom are listed. Particularly those that are using them to enable payments into gaming companies which Visa does not like.

It was another bad day in the market today, although Dunelm (DNLM) picked up after a very positive trading statement with good like-for-like figures. They are moving aggressively into on-line sales but their physical stores also seem to be producing positive figures so perhaps big retail sheds are still viable. They are not in the High Street of course.

While the market is gyrating I am doing the usual in such circumstances having been through past crashes. Will the market continue to go down, or bounce back up? Nobody knows. So I tend to follow the trend. But I also clear out the duds from my portfolio when the market declines – at least that way I can realise some capital gains losses and reinvest the cash in other shares that are now cheaper. I also look carefully at those stocks that seem to be wildly over-valued on fundamentals – those I sell. But those that suddenly have become cheap on fundamentals I buy, or buy more of. In essence I am not of the “hide under the sheets” mentality in the circumstances of a market rout as some are. But neither do I panic and dump shares wholesale. This looks like a short-term market correction to me at present, after shares (particularly in the USA) became adrift from fundamentals and ended up looking very expensive. But we shall no doubt see whether that is so in the new few days or weeks.

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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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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Brexit, Abcam, Victoria and the Beaufort Case

Another bad day for my portfolio yesterday after a week of bad days last week when I was on holiday. Some of the problems relate to the rise in the pound based on suggestions by Michel Barnier that there might actually be a settlement of Brexit along the lines proposed by Theresa May. This has hit all the companies with lots of exports and investment trusts with big holdings in dollar investments that comprise much of my portfolio. But a really big hit yesterday was Abcam (ABC).

Abcam issued their preliminary results yesterday morning. When I first read it, it seemed to be much as expected. Adjusted earnings per share up 27.1%, dividend up 17.1% and broker forecasts generally met. The share price promptly headed downhill and dropped as much as 32%, which is the kind of drop you see on a major profit warning, before recovering to a drop of 15.2% at the end of the day.

I re-read the announcement more than once without being able to identify any major issues or hidden messages that could explain this drop. The announcement did mention more investment in the Oracle ERP system, in a new office and other costs but those projects were already known about. Indeed I covered them in the last blog post I wrote about the previous Abcam AGM where I was somewhat critical of the rising costs (see https://roliscon.blog/2017/11/15/abcam-agm-cambridge-cognition-ultra-electronics-wey-education-and-idox/ ). The Oracle project is clearly over-budget and running behind schedule. A lot of these costs are being capitalised so they disappear from the “adjusted” figures.

The killer to the share price appears to have been comments from Peel Hunt that the extra costs will reduce adjusted earnings by 9% based on reduced margins. The preliminary results announcement did suggest that the adjusted EBITDA margin would likely be 36% as against the 37.8% that was actually reported for last year. Revenue growth of 11% is expected for the current year so even at the reduced margin that still means profits will grow by about 5%. That implies only a slight reduction in adjusted e.p.s. on my calculations which implies a prospective p/e of about 34. That may be acceptable for such a high-quality company with an enviable track record (which is why it is one of my larger holdings) but perhaps investors suddenly realised that the previous rating was too high and vulnerable to a change of sentiment. That realisation seems to be affecting many highly rated go-go growth stocks at present.

The excessive IT project costs are of concern but if the management considered that such investment (£33 million to date) was necessary I think I’ll take their word on it for the present. At least the implementation of the remaining modules is being done on a phased approach which suggests some consideration has been given to controlling the costs in the short term.

I attended the AGM of another of my holdings yesterday – Victoria (VCP). They manufacture flooring products such as carpets, tiles, underlay and also distribute synthetic flooring products (I think that means laminates etc). There was a big bust-up at this company back in 2012 in which I was involved. The company was loss making at the time but some major shareholders decided they wanted a change or management and lined up Geoff Wilding who is now Executive Chairman. After an argument over his generous remuneration scheme and several general meetings, it was finally settled. After meeting Geoff I decided he knew more about the carpet business and what was wrong with the company than the previous management and therefore backed him – a wise decision as it turned out. Since then, with aggressive use of debt, he has done a great job of expanding the business by acquisition and this has driven the share price up from 25p to 760p. Needless to say shareholders are happy, but there were only about half a dozen at the AGM in London.

I’ll cover some of the key questions raised, and the answers, in brief. I asked about the rise in administration costs. This arises from the acquisitions and investment in the management team apparently. I also questioned the high amortisation of acquisition intangibles which apparently relates to customer relationships capitalised but was assured this was not abnormal. This is one of those companies, a bit like Abcam, where the “adjusted” or “underlying” figures differ greatly to the “reported” numbers so one has to spend a lot of time trying to figure out what is happening. It can be easier to just look at the cash flow.

Incidentally the company still has a large amount of debt because that has been raised to finance acquisitions in addition to the use of equity placings. In response to another question it was stated that the policy is to maintain net debt to EBITDA at a ratio of no more than 2.5 to 3 times. But earnings accretion is an important factor.

Geoff spent a few minutes outlining his approach to acquisitions and their integration which was most revealing. He talked a lot of sense. He will never ever buy a failing company. He wants to buy good companies with enthusiastic management. Thereafter he acts as a coach and wants to avoid disrupting the culture. He said a lot of acquisitions fail as people try to change everything wholesale. One shareholder suggestion this was leading to a “rambling empire” but the CEO advised otherwise.

The impact of Brexit was raised, particularly as there is nothing in the Annual Report on the subject. Were there any contingency plans? Geoff replied that if it is messy it will help Victoria as a lot of carpet is made on the continent and a fall in sterling will also help. He suggested they have lower operational gearing than many people think but obviously they might be affected by changing customer confidence. The CEO said that Brexit is on his “opportunity list”, not his “problem list”.

A question arose about the level of short selling in the stock which seems to have driven down the share price of late. Geoff suggested this was a concerted effort by certain hedge funds but he was confident the share price will recover.

Clearly Geoff Wilding is a key person in this company so the question arose about his future ambitions. He expects to do 2, 3 or 4 acquisitions per year and life would be simpler if he didn’t do so many. He tends to live out of a suitcase at present. But he still hopes to be leading the company in 5 year’s time.

In summary this was a useful meeting and I wish I had purchased more shares years ago but was somewhat put off by the debt levels.

Lastly, there was a very interesting article by Mark Bentley on the Beaufort case in the latest ShareSoc newsletter (if you are not a member already, please join as it covers many important topics for private investors). It seems that the possible “shortfall” in assets was only 0.1% of the claimed assets with only three client accounts unreconciled. But administrators PWC and lawyers Linklaters are racking up millions of pounds in fees when the client assets could have been transferred to other brokers in no time at all and at minimal cost. An absolute disgrace in essence. Be sure you encourage the Government, via your M.P., to reform the relevant legislation to stop this kind of gravy train in future.

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

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Whitewash at Gordon Dadds AGM, and Insolvency Warnings

I attended the Annual General Meeting of law firm Gordon Dadds Group (GOR) this morning. The company was tipped as a buy in Investors Chronicle on the 3rd August so I bought a few shares. It’s always good to go to the AGMs of new investments to get an impression of the management and ask a few questions. This is one of only three listed legal firms (the others being Gateley and Keystone which I do not hold).

This AGM was very unusual in that both on the “show of hands” vote and the proxy vote counts, there were no votes against at all, i.e. exactly zero on all resolutions. That is exceedingly unusual for a public company. As I said to the Chairman, he managed to achieve that by not having a share buy-back resolution on the agenda as I normally vote against such resolutions. Likewise no resolution to change to 14 days notice of general meetings. I congratulated him on that and a well run AGM where questions were taken first before the formal business.

There were about a dozen shareholders present, some of whom might have been staff. I questioned the increase in overheads in the last year – they are working to bring that down but it was increased as they “set up to expand” – and the high debtors. Although they bill work in progress monthly, it seems their corporate clients are slow payers. Another shareholder asked how work in progress was valued, and it’s at cost apparently. Otherwise I did not pick up any concerns although the legal market does seem fragmented and it is not clear to me how they are differentiated from others although they do have some specialisations. One might see it as a market ripe for consolidation with too many small firms and Gordon Dadds seem to have acquisition ambitions.

The company only listed on AIM a year ago so it’s early days as yet.

Interesting that the national media failed to pick up on the changes to the insolvency regime announced by the Government last Sunday. Perhaps not surprising on a Bank Holiday weekend although I covered it here: https://roliscon.blog/2018/08/26/insolvency-regime-changes-a-step-forward/

Perhaps private investors were not concerned because they think they can bail-out before such events unlike institutional shareholders who frequently have such large holdings that they can’t place them on the market at any price. But you cannot always do so. I have been caught twice in over twenty years of investing by unexpected administrations of retailing companies who often appear to have lots of revenues and positive cash flows. But a retail market turn-down can catch them unawares when they have high fixed costs (staff and property rentals). The result is often a cash flow problem when quarterly rent payments are due, or an unexpected tax bill appears, or suppliers’ insurers simply get nervous and withdraw cover.

A simple ratio to look at to pick up businesses at risk of insolvency is the Current Ratio which I like to see above 1.4. Remember business only go bust when they run out of cash. However, retailers often pay their suppliers after they have sold the goods to their customers so the Current Ratio is not a reliable measure for retailers. Likewise it tends to be unreliable when looking at software companies where they might have deferred support revenue in their current liabilities which should really be ignored as it will never be paid.

The Current Ratio is easy to calculate (it’s Current Assets divided by Current Liabilities). A better measure but a more complex one is the Altman Z-Score. This was very well covered in this week’s Investors Chronicle where it was argued that it was also a good measure of the overall performance of companies. It’s not foolproof in terms of predicting insolvency but it’s certainly a good warning indicator – the big problem is that accounting figures on which it is calculated are often out of date.

The Z-Score can be obtained from a number of sources as it’s a bit tedious to calculate it yourself – for example Stockopedia display it on their company reports.

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

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Insolvency Regime Changes – A Step Forward

There’s nothing like issuing a major Government announcement on the Sunday of an August bank holiday weekend to get good media coverage is there? But as it’s raining and I have nothing much else to do, I have read the announcement and here is a summary:

The announcement is entitled “Insolvency and Corporate Governance – Government Response” (see https://www.gov.uk/government/consultations/insolvency-and-corporate-governance ). It is the Government’s response to past public consultations on how to tackle some of the perceived problems when companies get into difficulties or go bust. Such examples as House of Fraser (see my past blog posts on that subject where I called for reform of pre-pack administrations), Carillion, BHS, et al.

It aims to tackle issues around company director actions when a company gets into difficulties but one of the main proposals is very significant. That is that the Government intends to introduce a “Moratorium” scheme where a company can hold off its creditors for up to three months while it seeks to develop a restructuring proposal. Although a Moratorium will be a court process and will be supervised by a “Monitor” who is likely to be an insolvency practitioner, the directors of the company will remain in control albeit with some limitations.

Representatives of secure creditors (e.g. bank lenders) did not seem to like this idea at all based on their responses to the consultations, but it’s not quite as generous as first appears. Apart from the “monitoring” requirement to protect the interests of creditors, the initial period of a Moratorium will only be 28 days and can only be extended to 3 months if justified, and the company must be able to meet the normal insolvency rule that current obligations must be capable of being met as they become due during the Moratorium. But it is surely a step in the right direction in that it will provide more chance of those businesses that are not pure basket cases of being rescued to the advantage of trade creditors, pensioners and shareholders. That’s as opposed to the present situation where a pre-pack administration can instantly dump everyone except the secured creditors with massive damage to everyone else.

But directors of companies will need to act more in advance to ensure that a Moratorium is of help. To encourage them to do so the Government hopes to improve shareholder stewardship by identifying means to help the actions of institutional shareholders and others to escalate their concerns about the management of a company by its directors.

In addition the Government wishes to improve board directors effectiveness and training including raising awareness of their legal duties when making key decisions, and developing a code of practice for board evaluations. Comment: it is certainly the case that in smaller public companies the directors often seem to be unaware of their legal obligations and this sometimes extends to larger companies. I have argued in the past that all public company directors should have some minimal education in company law and their other responsibilities when acting as a director.

One issue examined was the payment of dividends by companies when companies were apparently in a weak condition such as having substantial pension liabilities or were paying dividends shortly before they went bust. Whether a company can pay dividends is governed by the calculation of whether it has “distributable reserves”, but that is a calculation that only the company and its auditors might be able to do. It’s not obvious from the published accounts. The Government is to work with interested parties on a possible alternative mechanism.

There were also concerns expressed that some companies are now paying dividends only as “interim dividends” which can escape approval by shareholders at Annual General Meetings. The Government has asked the Investment Association to report on the prevalence of the practice and they will take further steps to ensure that shareholders have an annual say on dividends if the practice is widespread and investor pressure proves insufficient.

In summary, I welcome all of these proposals as a step forward in rectifying some of the defects in the existing insolvency regime. The slight concern is that companies will be reluctant to enter a “Moratorium” due to the adverse publicity it might generate and the costs involved so we will have to see whether that turns out to be the case or not. But almost any restructuring solution is better than a formal administration or liquidation.

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

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Mulberry Profit Warning – Better Late Than Never

On Saturday (18/8/2018) I wrote about the damage to suppliers from the pre-pack administration at House of Fraser. One of the companies mentioned was Mulberry Group Plc (MUL) and I queried why they had not issued an RNS announcement indicating the likely impact on their profits. I suggested it could be £2.4 million.

This morning Mulberry issued a profit warning that spelled out the likely figure. There will be a provision of £3 million of “exceptional costs” related to the 21 “concessions” that they operated in House of Fraser stores. That arises from “a review of debtor balances, fixed assets and potential costs that may result from restructuring”.

For the avoidance of doubt, I have never owned the shares, nor bought their products. They do sell some nice handbags at £1,000 plus though. Both the products and the share price are too rich for me. At a prospective p/e of over 50 even before this morning’s profit warning, they must have some loyal followers.

The share price has fallen by 17% this morning at the time of writing. I hope shareholders in Mulberry will complain to the Insolvency Service (part of the BEIS Department – the responsible Minister is Kelly Tolhurst M.P.). The insolvency regime needs major reform.

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

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