The Departure of Sir Martin Sorrell

At last the highest paid and longest serving FTSE-100 CEO has departed from WPP after 33 years. His total pay last year was £48 million, down from the previous year’s “single figure” of £70 million. Sir Martin was certainly perceived to be a “star” businessman, and the financial performance of WPP pleased shareholders for many years. Despite recent problems the Annual Report of the company claims a Total Shareholder Return of 1,006% over the last twenty years as against a measly 241% for the FTSE-100.

Will the company find a suitable replacement manager who can continue to grow the business? Will the company survive in its current form or be broken up? Those are the questions all the media are pontificating upon.

My thoughts on this subject were crystalized by reading the business management classic “Good to Great” on a recent holiday break. First published in 2001, the author Jim Collins reported on research he had undertaken to determine what separated out simply “good” companies from the “great” ones, i.e. those that really offered investors superior returns rather than average ones. He also looked at what turned good companies into great ones, i.e. the crystalizing factors or turning points. It’s well worth reading by investors for that reason alone, even if some of the companies reported on as “great” have subsequently gone bust (e.g. Circuit City), and amusingly Berkshire Hathaway was only rated as “good” at the time so was not included in the analysis.

Management and the quality of the leadership was one of the key factors identified. It seemed that humble, self-effacing leaders were best. They often attributed the company’s success to luck or the other senior management team members. Star managers with high profiles such as Jack Welch at GEC or Lee Iacocca at Chrysler frequently proved to be shooting stars whose achievements rapidly disappeared after they left. In other words, they did not build great companies where their legacy lived on after their departure.

This is one very applicable quote from the book when you are considering director pay in companies: “We found no systematic pattern linking executive compensation to the process of going from good to great. The evidence simply does not support the idea that the specific structure of executive compensation acts as the key lever in taking a company from good to great”. In other words, high pay does not generate exceptional performance in managers, and schemes such as LTIPs which allegedly align managers’ interests with shareholders do not help either.

It’s a book well worth reading for tips on how to identify the companies and their CEOs that are likely to generate great returns for investors.

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

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GKN and Melrose – The Reality

Melrose has won the battle to take control of GKN although the Government might yet step in to halt the takeover. On what grounds is not exactly clear. Never having held shares in either company, I thought it worth looking at the facts rather than the hyperbole surrounding this deal as there seemed to be some myths being propagated.

Is GKN a key business in the UK’s engineering and technology infrastructure based on a long history of innovation? Or is it a financially poorly performing conglomerate that was vulnerable to a bid?

It has been said that GKN produced Spitfires in the Second World War but in reality they did not develop the plane but were just one of several assembly plants that were subcontracted to produce it in volume, In the 1960s I well remember the company under the name Guest, Keen and Nettlefold and in Birmingham they had large factories producing nuts and bolts. Hardly high-tech engineering even at that time. Later they did make a success of car parts production particularly with constant velocity joints (CVJs) as used in the Mini and other front wheel drive vehicles. But they are now proposing to split off the driveline business and merge it with another company. They plan to focus on the aerospace business. You can see a “polished” version of the history of the company here: https://www.gkn.com/en/about-gkn/history/ . In reality a long history of dubious diversifications, followed by later rationalisations.

The recent financial performance has been disappointing. Reported earnings per share in 2017 were the same as five years previously with a trough in between. Dividends in that period grew slowly and at the current share price equate to about 2% yield. Return on assets a measly 5.6% last year, and even that was an improvement on previous years. Although the financial prospects based on analysts’ forecasts might be slightly improving, is it not simply a case that institutional investors might have become disillusioned with the management in recent years and seen an opportunity in the Melrose bid to improve the financial returns?

There will no doubt have been some activity by share traders, arbitrageurs and hedge funds of late who might have influenced the outcome. But that’s capitalism in action. Holders, even long-term ones, sell to higher bidders.

Personally I oppose any suggestion that short-term holders should not be allowed to vote, and the use of other “poison-pill” mechanisms that can defeat takeovers. If I purchased a share in a company last week, I want to be able to vote it! I may not have known that a bid was coming and how I vote will depend on the arguments put by both sides. Clearly in this case GKN simply lost the argument.

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

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Conviviality – More Bad News, and IQE

I commented on the profit warning from Conviviality (CVR) on the 9th of March and the dangers of share tipping. Today the news is even worse. They have overlooked a payment of £30 million to HMRC due at the end of the month, so their cash flow forecast is blown asunder. They will breach their banking covenants unless some short-term funding is obtained to fill the hole. Meanwhile the shares have been suspended, and the dividend that was due to be paid on Friday has been cancelled.

I hope my previous comments dissuaded some investors from picking up these “bargain-basement” shares, but not all it seems. One of the punters was Stockopedia commentator Paul Scott. To quote his latest comment on it: “What can I say? It’s total incompetence”. It seems he was persuaded that the situation regarding banking covenants was OK after reading a positive broker note. But it seems likely the broker was relying on what the company told them.

I think there is one thing to remember when investing in companies and that is always to ask the question “do you trust the management”. Any announcements by companies should be always doubted unless the management have built up a track record of delivering on their promises and giving you the unvarnished truth. Regrettably, comments from brokers and other company promoters are never trustworthy in the modern financial world. When folks are being paid to say the right thing, or are financially motivated to do so, then whatever they say is likely to be dubious, or not the whole truth.

I have not commented on events at IQE before (I have never held the shares because it’s a sector I don’t like). But there was an interesting article by the Editor of Techninvest on the subject in the last edition (this is a publication focused on small cap technology companies and always worth reading). He commented negatively on shorting efforts by two companies while they published analyses of IQE’s accounts – effectively saying they were dubious. The company then issued a strong rebuttal and the shares bounced back. The shorters did not it seems consult IQE management before publishing, a pretty basic journalistic principle, particularly if you are going to publish negative allegations. The editor of Techinvest suggests scepticism should be exercised “given the vested interests involved”. I completely agree. One of the dangers of the modern internet is that folks can publish damaging stories with impunity, to their financial advantage. The Government and regulatory authorities surely need to tackle this issue sooner or later.

Whether the claims about the accounts of IQE have any basis in fact I would not like to comment upon. It would only stimulate more debate to no purpose when the real truth may be unknowable at this time. Investors should consider my comment above. Do you trust the management?

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

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The Dangers of Share Tipping, Alliance Trust and AIM Regulation

Share tipping is a mug’s game. Both for the tipsters and their readers. More evidence of this was provided yesterday.

Investors Chronicle issued their “Tips of the Week” via email during the day. It included a “BUY” recommendation on Conviviality (CVR). Unfortunately soon after the company issued a trading statement which said the forecast EBITDA for the current year (ending 30th April) will be 20% below market expectations. Conviviality is a wholesaler, distributor and retailer of alcohol and it seems there was a “material error in the financial forecasts” in one part of the business and that margins have “softened”.

The share price dropped by almost 60% during the day and fell another 10% today at the time of writing. This puts the business based on the new forecasts on a prospective p/e of less than 6 and a dividend yield of over 10% (assuming it is held which may be doubtful). Is this a bargain?

Having had a quick look at the financial profile I am not sure it is. Although net debt of £150 million may not be too high in relation to current revenues or profits, their net profit margin is very small and their current ratio is less than 1, although this is not unusual in retailers who tend to pay for goods after they have sold them.

(Postscript: Paul Scott of Stockopedia made some interesting comments on Conviviality including the suggestion that they might be at risk of breaching their banking covenants and hence might have to do another placing. Certainly worth reading his analysis before plunging into the stock. He also commented negatively on the mid-day timings of the announcements from Conviviality and Fulham Share which I agree with, unless there was some compulsive reason to do them – perhaps they were aware of the Investors Chronicle commentary being issued).

Another tip Investors Chronicle gave yesterday was on Fulham Shore (FUL) which they rated a SELL on the grounds that “growth looks unsustainable”. They got that one right. The company issued a trading statement on the day which also said EBITDA would be below market expectations. Their London restaurants are simply serving fewer customers. The share price dropped 17% on the day. This looks to be symptomatic of the problems of restaurant chains – Prezzo are closing a number of outlets which I was not surprised at because from my visits it seemed rather pedestrian food at high prices. Restaurant Group also reported continuing negative like-for-like figures recently, perhaps partly because of price cutting to attract customers back. Restaurants are being hit by higher costs and disappearing customers. Boring food from tired formulas is no longer good enough to make money.

Another announcement yesterday was results from Alliance Trust (AT.). This is a company that I, ShareSoc, some investors in the trust and hedge fund Elliott Advisors spent a lot of effort on to cause a revolution a couple of years ago so it’s good to see the outcome has been beneficial. Total shareholder return was 19.1% which was well ahead of their benchmark. There was a lot of doubt expressed by many commentators on the new multi-manager investment strategy adopted by the board of directors and the involvement of Elliott, who were subsequently bought out, but it has turned out very well.

The only outstanding issue is the continuing problems at Alliance Trust Savings. They report the integration of the Stocktrade business they acquired from Brewin Dolphin has proved “challenging”. Staff have been moved from Edinburgh to Dundee and the CEO has departed. Customer complaints rose and they no doubt lost a lot of former Stocktrade customers such as me when they decided to stop offering personal crest accounts. So Alliance have written down the value of Alliance Trust Savings by another £13 million as an exceptional charge. No stockbrokers are making much money at present due to very low interest rates of cash held. It has never been clear why Alliance Trust Savings is strategic to the business and it’s very unusual for an investment trust to run its own savings/investment platform. Tough decisions still need to be taken on this matter.

AIM Regulation. The London Stock Exchange has published a revised set of rules for AIM market companies – see here: http://www.londonstockexchange.com/companies-and-advisors/aim/advisers/aim-notices/aim-rules-for-companies-march-2018-clean.pdf .

It now includes a requirement for AIM companies to declare adherence to a Corporate Governance Code. At present there is no such obligation, although some companies adhere to the QCA Code, or some foreign code, or simply pick and choose from the main market code. I and ShareSoc did push for such a rule, and you can see our comments on the review of the AIM rules and original proposals here: https://www.sharesoc.org/blog/regulations-and-law/aim-rules-review/ and here is a summary of the changes published by the LSE: http://www.londonstockexchange.com/companies-and-advisors/aim/advisers/aim-notices/aim-notice-50.pdf (there is also a marked up version of the rule book that gives details of the other changes which I have to admit I have not had the time to peruse as yet).

In summary these are positive moves and the AIM market is improving in some regards although it still has a long way to go to weed out all the dubious operators and company directors in this market.

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

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FCA Action, Shareholder Rights and Beaufort

Better Finance, the European representative body for retail investors have issued a couple of interesting announcements this morning. The first compliments the UK’s Financial Conduct Authority (FCA) for their action over “closet index trackers”. They are investment funds that pretend to be active managers and charge the higher fees that normally apply to such funds, while in practice they hug their benchmark index. Other European regulators have been less than prompt in taking action on this problem it transpires.

It’s not quite as positive as that though as although a number of UK asset managers have voluntarily agreed to compensate investors in such funds at a cost of £34 million, and enforcement action may be taken against others for misleading marketing material, this appears to be a voluntary scheme rather than a formal compensation arrangement.

Which are the funds complained about? I could not find any published list. But back in 2015, the Daily Telegraph reported the following as being the worse ones: Halifax UK Growth, Scottish Widows UK Growth, Santander UK Equity, Halifax UK Equity Income and Scottish Widows UK Equity Income – all bank controlled business you will note.

The second report from Better Finance was on the publication of the final draft of the EU Shareholder Rights Directive. This was intended to improve the rights of individual shareholders but is in reality grossly defective in that respect. Even if implemented into UK law, it will not improve the rights for UK investors. Indeed it might worsen them. For example Better Finance said this: “Important barriers to cross-border shareholder engagement within the EU virtually remain in place, since intermediaries will by and large still be able to charge higher fees to shareholders wanting to exercise their cross-border voting rights (admittedly subject to certain conditions) and beneficial owners of shares in nominee and omnibus accounts will still not have any voting rights (with the exception of very large shareholders), to name but two of the remaining issues.”

Let us hope that the UK Government and the FCA take more positive steps to improve the rights of UK investors which have been undermined by the use of nominee accounts and other market practices adopted in recent years.

Another recent news item from the FCA was about the forced administration of Beaufort Securities and Beaufort Asset Clearing Services. Beaufort specialised in promoting small cap companies such as those listing or listed on AIM to private investors. But the US Department of Justice investigated dubious activities in relation to US shares and has charged the firm and some individuals involved with securities fraud and money laundering. These allegations appear to be about typical “pump and dump” schemes where share prices are ramped up by active trading of the shares by the promoters of companies, such that the prices of the shares sold to investors bear little relation to fundamental value, and then the insiders sell their shares leaving private investors holding shares which the market rapidly revalues downwards. On twitter one person published charts showing the share prices of companies that Beaufort promoted to investors and it does indeed look convincing evidence of abusive practices.

These kinds of share promotions by “boiler rooms” staffed by persuasive salesmen were very common a few years back and they seem to be coming back into favour as there are a number of other companies promoting small cap or unlisted stocks to investors. Regulations might have been toughened, and such companies are more careful to ensure investors are apparently “sophisticated” or can stand the possible risks and losses, but the FCA still seems slow to tackle unethical practices. Should it really have taken US regulatory authorities to take down this company? The FCA has been aware of the market abuse in the share trading of AIM shares for some time but no action has been taken. It’s just another example of how small cap shares, and particularly the AIM market, attracts individuals of dubious ethics like bees to a honeypot.

If you have invested via Beaufort in stocks, are your holdings likely to be secure? As they may be held in a nominee account it rather depends on the quality of the record keeping by Beaufort. Past experience of similar situations does not inspire confidence. It can take years for an administrator to sort out who owns what and in the meantime the assets are frozen. The administrators are PricewaterhouseCoopers (PWC).

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

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It’s a Bleak Mid-Winter

It’s a bleak mid-winter, everybody is hunkering down against the icy winds, Royal Mail have given up delivering post even in the London suburbs, and retailers are suffering. Well no, actually it’s the second day of Spring but the first was the coldest one on record. It’s not surprising that many people have a jaundiced view of the science of global warming.

But the stock market is drifting down and the news from many companies is dire. Let’s review some of those to start with. Note: I hold or have held some of the companies mentioned.

Safestyle (SFE) sell replacement plastic windows. You would have thought households would be rushing to replace their tired and leaking windows in the bad weather but apparently not. On the 28th Feb they announced a profit warning and the share price fell 37% in the next two days. Is that because of difficulties in installing in the bad weather? No, that will come later no doubt. The problem was lack of order intake so far this year. The real problem is “the activities of an aggressive new market entrant” in an “already competitive landscape” – the latter presumably referring to consumers cutting back on big ticket items. Historically the company showed great return on capital and good profits but the old problem of lack of barriers to entry of competition seems to be the issue.

Carpetright (CPR) also issued a profit warning yesterday. They now expect a loss for the year and blame “continued weak consumer confidence”. It seems they need to have a chat with their bankers about their bank covenants, but the latter “remain fully supportive”. I suspect the real issue here is not consumers (most buyers replace carpet in one room at a time so they are not exactly big purchases) but competition, including from Lord Harris’s son (Phil Harris was the founder and Chairman of Carpetright for many years). Other carpet suppliers (such as Headlam which I hold) have not seen such a major impact, but perhaps they are not as operationally geared as Carpetright. Or the bad news will come later.

Many retailers have faced a changing market – the market never stands still, with internet sales impacting many. Both Toys-R-Us and Maplin have gone into administration. The latter have no doubt been particularly hit by the internet and Amazon, but they have also suffered by private equity gearing up their balance sheets with very high levels of debt. Neither seemed particularly adept at keeping up with fashion. Might just be a case of “tired” stores and dull merchandise ranges. But why would anyone buy from a Maplin store when they could order what they needed over the internet (from Maplin, Amazon or thousands of other on-line retailers) and get it delivered straight to their door in 24 hours? In addition, many such on-line suppliers avoid paying VAT so Maplin was going to suffer from price comparisons.

But there has been some better news. IDOX (IDOX) published their final results yesterday – well at least there was no more bad news. They issued previous profit warnings after a dreadful acquisition of a company named 6PM, and the CEO, Andrew Riley, then went AWOL on health grounds. In addition there were problems with inappropriate revenue recognition, a common issue in software companies. Mr Riley has now definitely departed permanently and former CEO Richard Kellett-Clarke continues to serve as interim CEO.

The latest financial figures report revenue up 16% for the year although some of the increase will be from acquisitions. The profit figures reported on the first page of the announcement are best ignored – they talk about EBITDA, indeed “adjusted EBITDA” and “adjusted earnings”. I simply skipped to the cash flow statement which indicated “net cash from operating activities” of £13.4 million. That compares with a market cap at the time of writing of £152 million, so the cash earnings yield might be viewed as 8.8%.

They did spend £24.3 million on “investing activities”, mainly financed by the issue of new shares, last year and much of that might effectively have been wasted. But cash flow going forward should improve. Unadjusted diluted earnings per share were very substantially reduced mainly due to increased overheads, higher amortisation and high restructuring and impairment costs. These certainly need to be tackled, but the dividend was increased which shows some confidence in the future.

The share price perked up after the results announcement but some commentators, such as my well-known correspondent Tom Winnifrith, focused on the balance sheet with comments such as “negative current assets” (i.e. current ratio less than one) and less polite phrases – he does not pull his punches.

Any accountant will tell you that a company with a current ratio (current assets divided by current liabilities) of less than 1.4 is likely to go bust simply because they risk running out of cash and will not be able to “meet their debts as they become due” (i.e. will become insolvent).

Am I concerned? No because examination of the balance sheet tells me that they have £19.8m of deferred income in the current liabilities (see note 18). This represents support charges which have been billed in advance for the year ahead. Such liabilities are never in fact crystalised in software companies. So deducting that from the current liabilities results in a current ratio that is a positive 1.7.

The balance sheet now does have substantial debt on it, offset by large amounts of “intangible” assets due to capitalisation of software development costs which many folks would ignore. The debt certainly needs to be reduced but that should be possible with current cash flow, and comments from the CEO about future prospects are positive. That is why the share price rose rather than fell I suggest on the announcement, plus the fact that no more accounting issues had been revealed.

There are promises of Spring next week, so let us hope that this will improve the market gloom that seems to be pervading investors of late. Even retailers may do better if shoppers can actually get to their shops. We just need the sun to come out for a few days and flower buds to start opening, for the mood to lighten but I fear my spring daffodils have been frozen to death.

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

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The Art of Execution – Essential Reading For Investors

I am an avid reader of newsletters and the national press on investment matters and noticed a couple of writers recently mentioned very positively the book “The Art of Execution” by Lee Freeman-Shor. I have now read it myself and it’s definitely a book every stock market investor should read. Here’s why:

There are thousands of books available on investment, aimed at both neophyte and experienced investors. They tend to fall into two main groups: those teaching you how to pick out good investments and those explaining how successful past investors have operated. Incidentally reading the latter ones simply tells you that there are many different styles that can be successfully used. But the main problem with the former approach alone, as the author points out, is that even with the most expert fund managers (and the most highly paid), only 49% of their “best ideas” made money when he analysed their performance.

Mr Freeman-Shor managed investors in his role as a fund manager at Old Mutual Global Investors and studied all the deals they did over seven years. Some investors made money for him overall but others did not, and the main differentiator was how they reacted to various circumstances, not their skills in initial stock selection.

Every investor faces decisions. When your favourite stock, where you have a big holding, drops 20% do you cut your losses and sell, or buy more? When another stock rises by 20%, 30% or more do you sell it to realise profits in fear of it falling back? Or do you buy more? Or perhaps you sell some and keep the rest (“top slicing” as it is called)? Do you worry when your portfolio ends up with 40% or 50% in one or two holdings?

Many investment gurus tell you to use a “stop-loss” to avoid big mistakes, but Freeman-Shor explains that many successful managers actually bought more if they believed in the fundamentals of a company. Clearly there is more to this subject of successful execution than the simple rules advocated by many. What really differentiated the successful investors is not how good they were at picking out winners, but how they managed their holdings later. He identifies a few distinct styles which differentiate the winners from the losers.

One of the handicaps of professional investors the author identifies is their unwillingness to take risks in case they get fired for short term underperformance. So they tend to over-diversify and take profits too early. These are bad habits that private investors can avoid.

There is much in this book that I have learned myself from 30 years of investing. But the author identifies the key habits and investment styles than can be successful. Essential reading for any new investor and highly recommended. And also interesting for those already experienced.

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

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