Category: Laws & Regulations

ETFs and Index Trackers – More Dangerous Than You Think

Lots of financial pundits have encouraged investors to be “passive” investors rather than try to pick stocks, or invest in funds that do that latter (“active” funds). Even the FCA has recently criticised active funds for being more expensive and the additional management fees end up impacting negatively on overall returns over time. So persuasive writers such as John Bogle have convinced many to take the “no brainer” route of buying Exchange Traded Funds (ETFs) or other index tracking funds.

But there are surely dangers creeping up on all of us from this approach evidenced by several interesting articles in the Financial Times and Investors Chronicle in the last week.

On the 7th August John Plender in FTfm showed how index tracking funds break prudent portfolio rules. He warned about the concentration of holdings in Nasdaq stocks where the top five holdings (Apple, Google (Alphabet), Microsoft, Amazon and Facebook) represent 41 per cent of the index. He said “Concentration risk that is forbidden to an active manager is considered reasonable if it happens to be an index. This is dangerous nonsense”.

The Editor of Investors Chronicle published an editorial that warned that one of his worries was the huge inflows to passive funds and said “But I am concerned at the presentation of ETFs as an investment panacea because it has created the impression that investing is easy and riskless”. That is surely very true as private investors have simply bought more and more lately in a steadily rising market in recent years, driven by “momentum” trading styles. They don’t look at the valuations of what they are buying (hey – the index must be the best valuation is it not), they just buy and sell regardless based on trends. As the IC editor also said “What happens when the US bull market comes to an end?”. A good question indeed to which there is an obvious answer – a market crash as investors who have never been through a bear market capitulate.

Just today we have a front page article in the FT headlined “surging flows into exchange traded funds drive US stocks bubble anxiety”. It covers the record breaking in-flows into ETFs this year so far. It includes a good quote from Howard Marks of Oaktree Capital: “When the management of assets is on autopilot, as it is with ETFs, then investment trends can go to great excess”.

I certainly agree that investors need to examine very carefully the costs of the funds they invest in, if they do not wish to invest directly in shares. There may even be a place for index trackers in a portfolio – not that I hold any. But the real worry is that ETFs are now distorting the market and protecting yourself against that distortion, or from the likely collapse when everyone realises the emperor has no clothes, is not easy. It has led to a general rise in asset prices, in particular share prices, while simply staying out of the market while this is going on does not make much sense either.

The situation is surely analogous one of the causes of the great Wall Street crash of 1929 where “trusts” dominated the market and were sold to investors on the basis that they only went up. That was not helped by trusts investing in other trusts in a kind of pyramid scheme, and by low cost finance to purchase shares on margin – and we surely cannot get much lower interest rates than we have now. Restrictions on credit was one immediate cause of the 1929 crash, causing margin calls to be invoked and a spiral down.

There is no simple solution to protect oneself against the hysteria of momentum investing and index tracking, but the most vulnerable shares are undoubtedly those that form a large part of any index. Those are the ones where valuations may become unrealistic and where active traders may not feel it wise to try to sail against the wind. So the message is surely to look askance at unreasonably high valuations in relation to earning or cash flows in companies. Simply “buying the index” when everyone else is doing so is not a sound approach.

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

Disclaimer: Read the About page before relying on any information in this post.

The Internet of Things – Telit and Tern

Most investors in AIM will have noted the unfolding news at Telit Communications (TCM) last week. It has culminated today with an announcement from the company that CEO Oozi Cats (a.k.a. Uzi Katz) has resigned after an independent review did indeed find that he was the subject of a US indictment 25 years ago which had not been disclosed to the board. However, they denied that other allegations about the operations and finance of the company were true. Specifically, they said “there is no substance to the speculative and accusatory articles that have been published and that it stands behind the Group’s audited accounts to 31 December 2016 and the most recently published interim statement”. Will the publisher receive yet another threat of legal action as a result? We will see, although companies are reluctant to spend time and money on such cases and it is more difficult for them (as opposed to individuals) following recent changes in libel law.

Is this yet another example of how AIM regulation is defective? The simple answer is no. Both I and ShareSoc have campaigned for improvements in that area, and the LSE have recently published a paper entitled “AIM Rules Review” which has some helpful suggestions.

But the alleged legal problems of the CEO and his wife were 20 years before the company even listed on AIM in 2015 so no amount of due diligence was likely to have discovered that issue. The more recent allegations – which are about possible fraud at the company – are not an issue of AIM regulation. Possibly more an auditing issue if any such problem exists, which the company clearly denies. However, one has to question the willingness of AIM to list companies based in foreign countries some years back. Why did they list on AIM rather than in Israel or the USA for example? Possibly because they thought there would be less scrutiny. There does appear to be more examination of new listings of late and it’s covered in the paper mentioned above also.

Now I have never invested in Telit, although I have looked at it more than once in the past. There were several aspects about this company (other than the country of residence) that put me off. The nature of the product was one – albeit it’s operating in a hot sector but was there good protectable IP? Others were the lumpy nature of hardware orders, the directors and their pay, the issue of director share sales, the failure to turn profits into cash, the repeated fund raisings…..I could go on.

In summary, this is the kind of company I do not want to own.

It’s probably just another example of a persuasive CEO encouraging investors, often unsophisticated private investors, to punt on a concept of rapid growth in a hot technology sector.

Interestingly another company focused on the “Internet of Things” sector is investment company Tern (TERN) who raised some funds via platform Primary Bid over the weekend via a placing and open offer. The latter closed early due to the demand. Indeed, the COO of Primary Bid said: “We are delighted to have facilitated the fundraise for Tern plc. It was good to see such strong demand for this Offer, demonstrating how popular Technology related companies can be with tech savvy PrimaryBid Investors. More than 50% of all investors subscribing for this offer did so via a mobile device”. Note particularly the last sentence.

I had a quick look at Tern, but had great difficulty in valuing the company because it’s largest investment by a long way is a holding in a company named Device Authority Ltd. Is there any information provided on the revenue or profits of that company in the announcements about the fund raising or in recent past company announcements, or are there any recently published accounts filed at Companies House for this UK registered company? Apparently not, so any “due diligence” is difficult. But Tern does not look expensive at face value because of their revaluation of the investment in Device Authority last year by the company in the same way as any other private equity investment is valued.

Is this another case of over-enthusiasm by private investors to get into this high tech world? We shall no doubt see in due course.

There is another thing which Telit and Tern have in common. They have both been harassed by the same “journalist”. Indeed, director Angus Forrest of Tern even went so far as to report him to the police for harassment in 2015 although the matter was not pursued (harassment can be both a criminal law and civil law case).

Investors are recommended to take a cold shower whenever anyone talks about hot technology sectors. A lot of businesses in them never turn a profit, or give a decent return on investment. You just have to look at the early history of Apple – now the largest company in the world by market cap – to see how tortuous and extended can be the path to success. And most of their early competitors simply disappeared.

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

Disclaimer: Read the About page before relying on any information in this post.

Why Institutions Cannot Control Pay

An interesting article in the Financial Times FTfm supplement on Monday helped to explain why pay is so out of control in public companies. In an interview with Rakhi Kumar of State Street Global Advisors, she made it plain what the problem is.

State Street may not be a household name in the UK, but they are one of the world’s largest fund managers. Fourth in size behind only Blackrock, Vanguard and UBS according to Wikipedia. Last year State Street had more than 4,000 pay proposals to review globally. They used a filter to identify 1,000 proposals that were the most controversial (implying that they did not even look at the other 3,000 and automatically voted “for” the others rather than abstained). They only voted against 300 of them.

It’s actually even worse than the above comments indicate because only this year have they started to include “quantum” of pay in the screen. In other words, the amount of money paid to chief executives was not even considered in the screen. So outrageous levels of pay would not even have been looked at. One can see exactly why companies like State Street, Vanguard and Blackrock who dominate all major stock markets have been criticised for their role in letting pay get out of hand.

Now this writer has a large portfolio consisting of over 70 stocks. I receive all their Annual Reports and vote all my shares at the AGMs where practical to do so (regrettably not always easy in nominee holdings). I have the same problem as State Street in that I do not have time to read the detail of all the Remuneration Reports which now can stretch to more than 30 pages. So here are a few tips on how to handle the task to help folks like State Street:

State Street may not be a household name in the UK, but they are one of the world’s largest fund managers. Fourth in size behind only Blackrock, Vanguard and UBS according to Wikipedia. Last year State Street had more than 4,000 pay proposals to review globally. They used a filter to identify 1,000 proposals that were the most controversial (implying that they did not even look at the other 3,000 and automatically voted “for” the others rather than abstained). They only voted against 300 of them.

  • I speed read the comments of the Remuneration Committee Chairman to see if there is anything of note.
  • I review the quantum of pay for the two highest paid directors (which for UK companies is easy now there is a “single figure audited remuneration” table). Is it reasonable in relation to the size and profitability of the company? If not, I vote against the Remuneration Report (and Policy if that is on the agenda). Any figure over £1 million, regardless of the size of the company I am likely to consider unreasonable. Similarly, any company where pay has gone up while profits and/or dividends have gone down is viewed negatively. The pay of non-executives I would also glance at.
  • I look at the LTIPs (which I generally don’t like at all) and bonus schemes. Any of those that enable more than 100% of basic pay to be achieved I vote against.

So that’s it. A quick and effective approach to making decisions on pay which can take about 5 minutes. It may not be perfect, but it is better than abdicating one’s duty altogether.

ShareSoc has published some Guidelines on how to set pay which gives more details and may be more helpful for smaller companies if you want to consider things in more detail.

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

Disclaimer: Read the About page before relying on any information in this post.

Halma AGM and Sophos Capital Markets Day

On Thursday (20/7/2017), I attended the Annual General Meeting of Halma Plc (HLMA). Not exactly a household name so you may not know what they do. In summary, they have a “diversified portfolio of businesses” that are focussed on safety, health and environmental products. Lots of niche businesses in growth sectors and they define their segments as Medical, Infrastructure Safety, Environmental & Analysis, and Process Safety. Revenue last year was £961 million, with post tax profits of £129 million.

What attracted me to this business was the steady, consistent growth over many years and good return on capital (they give as 15.3% Group Return on Total Invested Capital) with good cash flow and moderate gearing. This has been achieved under CEO Andrew Williams who has been in the role since 2005 which must make him one of the longest serving CEOs in a FTSE company. In addition, the Finance Director, Kevin Thompson, has been in the role since 1997 although he is planning to retire in 2018.

Mr Williams gave a short presentation (interesting to note that the Chairman said little and the Annual Report only contains a statement from the CEO, not the Chairman, as would be more normal.

He said that Halma has a simple growth strategy. Focus on growing markets, e.g. healthcare, while looking to acquire businesses with technology or application knowledge. Wrapped around this is a simple financial model – they aim to double earnings every five years, without becoming highly geared or seeking further equity, provided there are similar rates of organic, acquisitive and dividend growth (to quote from the Annual Report – which is a very comprehensive document if somewhat weighty). Yes they do make acquisitions but these seem to be mainly smaller ones that are complementary and easily integrated.

As Mr Williams said, this strategy has “consistently delivered”.

Questions from shareholders were then invited.

I asked whether they hedged against currency fluctuations because I noted that the increase in profits last year (up 16.9% on an “adjusted” basis) included 10.5% that arose from exchange rate movements (Note: pound falling as a result of the Brexit vote when the company is a very international business – clearly it may be that the pound will move in the opposite direction sometime). The answer given by the FD was that they don’t hedge profits in the group structure. I also asked about the possible impact of Brexit. The CEO said as only 10% of company trading was to/from Europe they did not consider it likely to be a significant problem. No plans to counter had apparently been made.

In summary, on a prospective p/e of 25.3 and yield of 1.3% this company does not look particularly cheap but that’s true of most quality businesses in the current bull market. As most of their revenue and profits are from outside the UK, you might look at it as a hedge against Brexit damage but the company is certainly vulnerable to swings in the pound/dollar/Euro exchange rates.

There is a fuller report of this AGM available to ShareSoc Members.

Sophos

One thing I noted when I read the Annual Report of Halma was that the Chairman was also a director at software security company Sophos. They are holding a “Capital Markets Day” on September 6th, the day before their AGM. As I hold the shares, I asked investor relations if I could attend. They suggested it was really only for “analysts” and “institutional investors”. Now this is prejudicial to private investors and I reckon I have enough knowledge of the sector, and a large enough investment portfolio to justify attendance. But they fobbed me of with an offer of being able to attend on-line. Will that happen? We will see. For those who are not familiar with Capital Markets Days, these are much more in-depth reviews of a company than most investors see.

But in the meantime, I complained to Paul Walker who will take it up. I may go to the AGM also to complain.

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

Disclaimer: Read the About page before relying on any information in this post.

 

AIM Rules Review

The London Stock Exchange have published a document entitled “AIM Rules Review”. ShareSoc, including me personally, have criticised the LSE in the past for poor regulation of the AIM market. Many investors view it as a casino because of the numerous problems of fraud, poor disclosures, many delistings or simple bankruptcies in AIM companies. See the ShareSoc campaign page here for more information: https://www.sharesoc.org/campaigns/campaign-improve-aim-market/

As you can see we made a number of recommendations on how to improve the AIM market, and had meetings with AIM management where we put these proposals forward. The LSE regulates the AIM market but their responsibility lies primarily in ensuring the AIM Rulebook is adhered to and that Nomads meet their responsibilities. Other aspects of the market such as market abuse or false accounting are covered by other regulatory bodies, which many private investors do not understand.

So have any of the ShareSoc proposals been covered in the latest document? In summary, yes they have been. Here’s a quick review:

The AIM Rules Review does emphasise the improved recent performance of the AIM market and the fact that the average size of companies listed on it is growing. That has helped to improve the quality of the market.

Vetting new listings. One proposal we made was that new listings should be vetted by an independent panel because many investors considered some of the new listings in the past to be very dubious businesses. They have not taken this up directly but are proposing to formalise the “early notification process”. In addition, they propose to give more guidance to Nomads (whose role it is to perform due diligence on prospective listings) on what they need to take into account. For example, the “good” character of directors or managers, the corporate structure and business model, risky contractual arrangements and “related party” interests. This looks to be one way to tackle past problems, but one suggestion I would make is to add to that list the “regulatory structure and upholding of the rule of law in the countries where the candidate is listed or operates”. For example, it has proved very difficult to pursue fraud in China, and even Greece creates difficulties in that regard.

Free float. One concern they cover is the issue of low free floats which is a concern of some investors. For example, many of the companies that have turned out to be problem ones are those where there is an executive Chairman who holds a majority of the stock (or their close relations or associates do). This gives that person enormous power to prejudice minority shareholders, ignore the views of other board members and ultimately commit major frauds. The LSE’s response on this issue though is simply that the LSE would like to understand the position on new applications and the Nomad’s consideration of it. That surely is open to abuse, but the LSE does ask whether more specific free float rules should be brought in (the LSE document is a public consultation one so you can submit your own comments).

Minimum Fundraising. They also propose the introduction of a minimum fundraising rule and pose some questions on that. This would help to ensure institutional involvement in a company.

Composition of Boards. They mention this, but give no specific suggestions. That is surely an omission when ShareSoc made some specific suggestions in that regard.

Disclosure and Corporate Governance Codes. The document covers the issue that AIM companies can avoid any adherence to a specific corporate governance code. ShareSoc suggested a specific code should be available and applied by all AIM companies. The LSE asks a question on this at least.

Education and Breaches of the AIM Rulebook. The LSE asks how the market, particularly individual investors, can be further educated as to what the LSE can and cannot do. A good question indeed, which I will ponder.

Breaches of the AIM Rules. But one issue we raised with AIM management was the failure to enforce the existing Rules, or penalise and publicise those who break them. Indeed the document spells out how poor this has been by giving some statistics. There were 93 recorded breaches or where “education” was required, but only 16 warning notices or private censures/fines issued on average over the last three years. There were zero public censures apparently. They do ask a question about possibly imposing automatic fines on breaches of the AIM Rules, and invite suggestions for other changes. I will have some, but the basic problem is “self-regulation” and the resulting unwillingness to take tough action. Both firmer rules on penalties and a cultural change is required.

In summary, this Discussion Paper on the AIM Rules is a useful step in the right direction and does appear to tackle some of the issues about AIM that I and ShareSoc raised. It is though only a discussion paper and hence that does not mean necessarily that action will be taken. In some regards it is still quite weak but regrettably AIM management have an uphill battle to get change adopted when many market participants consider everything in the garden is rosy. However, it is surely necessary to improve the reputation of AIM if the market is to attract more listings and reduce the number of complaints from investors.

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

Disclaimer: Read the About page before relying on any information in this post.

First blog post

This blog is written by Roger W. Lawson and covers topical news and comment on investment (particularly stocks and shares), on corporate governance, on company management, on economics, on transport, on art, on events in London and on local and national politics. It will also cover anything else that I feel may be of general interest to my readers or where I have a burning desire to discuss a topic.

As some readers may know, I have been writing articles and blog posts on stock market investment for many years, more recently mainly for ShareSoc – an organisation for private investors. I will continue to do so as I support the objects of ShareSoc, therefore you may find similar blog posts on their web site as appear here.

This blog may cover a wider remit though in that I won’t shy away from controversial issues as much as a “responsible” national organisation has to do. In this case you are simply getting my personal opinions, but I will of course always try to get the facts straight to support any stance. If that offends some people then so be it. One cannot produce interesting and lively articles while pandering to the sensitivities of everyone in this world.

It will also cover some other areas of interest to me than stock market investment.

I hope you find it a good read.  Review what it says in the “About” section for more background information.

Roger Lawson