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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Aviva Preference Shares – FCA Announcement

Readers who take any notice of financial affairs will be aware of the furore over the threat by Aviva to redeem their preference shares by a “share cancellation” process – they claimed that is a different legal process, even though the shares were described as “irredeemable”. The shares concerned dropped in price to a significant extent because their high coupon interest rate meant they were trading at a premium when cancellation would have meant redemption at the original par value. Aviva have reconsidered the matter, but the interesting aspect today was a response from the Financial Conduct Authority (FCA) to a letter from the Treasury Select Committee. You can read it here: https://www.investegate.co.uk/financial-conduct/rns/fca-response-to-tsc-on-aviva-plc-preference-shares/201803280704471964J/

It basically gives lots of reasons why they cannot yet respond to some of the questions as they are still looking into the issues, but in response to Question 4 they seem not to concede that they should be involved in “the resolution of the legal questions”. In other words, they would be quite happy to leave it to an enormously expensive law suit by investors to resolve the key questions.

They do not seem to accept that they have an overriding objective to ensure a fair market for securities and that investors should not be prejudiced by small print, concealed or opaque legal terms and other sharp practices.

The response to Question 6, seems to try and excuse the problem by saying the shares were issued more than two decades ago and the FCA has taken subsequent action “in order to restrict the retail distribution of regulatory capital instruments….”. This is surely not an adequate excuse. The shares concerned were and are publicly traded and there is nothing stopping any investor (at least a “sophisticated” one) from trading in them. But even sophisticated private investors and some institutions were caught out by the unexpected threat from Aviva.

The FCA is again proving to be toothless in the face of seriously unethical practices. In other words, they are not doing their job competently and should be reformed in my personal opinion. I believed the FCA adopted an objective of more “principle-based regulation” a few years back but now seem to have abdicated that responsibility and are quite happy to let lawyers argue over the wording of a prospectus while ignoring the ethical issues. Just as they did with the RBS and Lloyds cases. It’s simply not good enough to issue the kind of response they have to the Treasury Select Committee.

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

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Libel Settlement – Peace Breaks Out

Some readers of this blog may have become aware that I was pursuing a libel action against Tom Winnifrith of ShareProphets. Tom writes a newsletter which many private investors read, and he often tackles the dubious activities of some public companies and their directors – particularly AIM companies – which can only be applauded.

Our legal dispute has now been settled and Tom has withdrawn his allegations to my satisfaction. He is in the process of removing them from the web. He has even gone so far as to call me an “underlying good person” in a recent podcast so I am feeling quite saintly at present. I hope readers will not hear more about this matter.

The following statement was agreed by both parties as part of the Settlement Agreement.

Roger Lawson & Tom Winnifrith: a joint statement

Roger Lawson and Tom Winnifrith have agreed that Mr Lawson’s legal action against Tom Winnifrith for libel will not be pursued further. Life is too short. Both men are agreed that nearly all of the work done by each other on seeking reform of AIM and in campaigning against poor corporate governance is worthwhile. There are too many ways in which the stock market needs reform and too many individuals who break the rules that do exist, for energies and money to be wasted on a fight that will enrich only lawyers. 

Tom Winnifrith stated: I stand by my assertion that Roger Lawson should have declared ownership of shares when writing about them at all times and it would have been better practice to have advised readers to sell before doing so himself. But Roger acted in line with the rules for the ShareSoc blog and other publications. More importantly I am sure that he did not act in the way he did in order to secure personal financial gain. Nor did he secure a gain as a result. Roger can be somewhat cantankerous but his heart is normally in the right place; he is not the sort of man I want to be fighting, especially as on most issues we are in agreement. My energies should be focussed on the bad guys and Roger is not one of them. 

Roger Lawson stated: Like most people I find Tom Winnifrith’s language not always to my liking. However on most occasions when he goes after a company his judgement is shown to be correct and in doing that he performs a valuable service. In publishing the Globo dossier he showed bravery other journalists baulked at and with hindsight he asked all the right questions of blinkx and Globo. Since we agree on far more than we disagree on it is right that instead of making lawyers rich with any law suit we both move on and continue to offer fair criticisms of the London market and to fight on behalf of ordinary investors.

<End>

Part of the dispute was about the fact that I sometimes commented on shares that I owned. That continues to be the case on this blog, although I frequently comment on shares that I have never had any financial interest in whatsoever (for example Autonomy in my last blog post simply from my knowledge of the IT world). Excluding shares that I have owned would not make sense as I often have a deeper understanding of those companies than any financial journalist could quickly acquire. Readers should read the About page on this blog to understand the legal terms that apply to the content and use of this blog which covers that point, although I would normally declare any interest in shares when I write about them.

Postscript: Readers are reminded that I never give buy or sell recommendations on shares, and have never done so in the past. I try to give a balanced view about companies so if I point out positive aspects I am likely to also include the negative aspects. A good example is my recent comments on Rightmove Plc. Whether my comments are fair and accurate at the time you will need to judge for yourself, and hindsight can distort the picture. I am generally dubious about the ethics of those who comment negatively on companies in public while shorting the shares and likewise I do not appreciate those investors who puff shares they hold – even institutional fund managers are frequently guilty of “talking their own book” which I consider a dubious practice. It is unfortunate that the ethics of the financial world leave a lot to be desired and “fake news” is a growing problem.

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

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Autonomy Legal Case and Revenue Recognition

There is an interesting report in today’s Financial Times on the legal case against the former CFO of Autonomy. Leading British software company Autonomy Plc was acquired by Hewlett Packard for $11 billion but subsequently had to write it down by $5 billion. They alleged that Autonomy had inflated the value of the business by various accounting practices and that is now the subject of a civil law suit.

But the interesting aspect is that the former CFO, Sushovan Hussain, is facing a criminal court today in California for 15 counts of conspiracy and wire fraud associated with the alleged falsification of Autonomy’s accounts. The UK’s Serious Fraud Office did look at the case but dropped it in 2015.

Mike Lynch of Autonomy has vigorously denied the allegations and has even set up a web site to defend himself and others against the allegations. You can read his side of the story here: https://autonomyaccounts.org/

But for investors the FT article gives a nice list of the abuses that are alleged and are common in software companies. They include:

  • Booking transactions to resellers as revenue when there was no end-user license (i.e. “channel stuffing” as it is sometimes called).
  • Engaging in “round-trip” transactions where purchases were invented so it could pay money to companies which then returned it to Autonomy to cover fictitious sales.
  • Backdating sales transactions so they fell into a previous accounting period.

There is also a claim previously reported that bundles of hardware/software sales were treated as solely software in the accounts. Why does this matter? Because software sales are valued in company valuations much more highly than hardware sales.

The above are some of the things that investors in IT companies need to look at although abuse can be difficult to spot in the published accounts of a public company. High accounts receivable and apparent lengthy payment delays can be clues. There were some questions raised about Autonomy’s accounts even before the takeover.

One claim by Autonomy’s founder, Mike Lynch, is that some of the disputed differences are simply down to different accounting standards (US GAAP versus IFRS), but I am not sure that stands up to scrutiny.

Hewlett-Packard are effectively saying they were sold a pup, while Autonomy executives deny wrong-doing and blame HP for not reading their due diligence report carefully, screwing up the subsequent integration and then searching for a scapegoat after what turned out to be a disaster of an acquisition.

But if the SEC’s California prosecutors make the charges stick then there may be more problems for Mike Lynch.

The auditors of Autonomy were Deloittes.

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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KIDS – Who Is Kidding Who?

There was an interesting article published by Citywire yesterday on the subject of Hargreaves Lansdown removing 96 investment trusts from its trading platform. Such trusts as Dunedin Enterprise, Blue Planet and Oryx International Growth have been suspended. The reason is because they have not yet made available a “KID” (Key Investment Document) which is required by the new PRIIPS regulation and mandated by the FCA/EU from the start of this year (see https://www.fca.org.uk/firms/priips-disclosure-key-information-documents for more information).

At present investment trusts are mainly affected. Unit trusts and OEICs that are UCITS have another two years to comply.

The Citywire article quoted Annabel Brodie-Smith and Ian Sayers of the AIC (trade body for investment companies) as saying it was only a transitional problem but that the mandatory performance figures in the KID “will in some cases, be suggesting too favourable a view of likely future performance” and the “single-figure risk indicator will potentially be understating the risks”. Mr Sayers has also criticised the fact that open-ended funds will not need to disclose underlying transaction costs when investment companies will need to do so, thus making comparisons difficult.

Investment Trusts are of course a peculiarly British investment platform whereas most of Europe use open-ended funds, and hence the legislation was focused more on the needs of the rest of Eurupe rather than the UK. The UK already had quite extensive disclosure of fund information, particularly for investment trusts which was published in such documents as a “Monthly Factsheet” with performance date readily available from the AIC web site, Trustnet and other sources.

I posted a comment on the Citywire article which said: “The regulations impacting investment trusts are a typical example of EU laws written by folks who do not understand the UK market environment, and are also generally ignorant of the financial world. The sooner we depart the better. Expensive and incompetent bureaucracy in more ways than one.”

That immediately prompted the usual abusive comments from EU lovers – anonymously of course. A vigorous debate then followed. So what is the truth? Are KIDs going to be useful? Were some trusts deficient in being up to speed on making KIDs available? Is the additional expense of producing a KID worthwhile?

Now it is undoubtedly the case that some investment trusts might have been tardy in meeting the regulations (although I believe Dunedin Enterprise Trust is winding down so they might have not put a high priority on it). But as it will prevent purchases but not sales, this needs to be rectified as soon as possible otherwise prices might be distorted.

But are KIDs useful? You can see one for JPMorgan Euro Smaller Companies Trust (a trust I hold) here: https://documents.financialexpress.net/Literature/83197092.pdf ). The risk rating is simplistic and the “performance scenarios” are likewise. It shows that over 5 years a holding in this trust might generate a negative return of 18.62% per annum, but in a “favourable scenario” you might make 36% per year. Does that help you? Not a lot.

That is particularly so as those figures are forecasts, not the real historic data. In comparison the information on the AIC web site or the company’s web site, including in the company “Factsheet” is much more comprehensive and more helpful. For example, it tells you about the historic price performance versus the net asset value performance (and over several time periods), the discount levels, the performance against a benchmark and lots more data.

The KID does have some useful information on costs, as it includes transaction costs. As a result it gives the “Impact on Return” due to costs of 2.81% per year whereas the AIC reports an “On-going” charge of 1.13% for this company because they don’t include transaction costs. This is a company that does not have a performance fee though which would complicate reporting on other trusts.

The objective of the KID to standardise the reporting of basic information on investment funds, and provide consistent and accurate “all-in” cost data was laudatory. But the implementation is a dog’s breakfast with the result that investors are hardly likely to spend a long time looking at these documents even if they are forced to do so.

On the latter point, the Share Centre now require you to tick a box to say you have read the KID before buying the shares, but other platforms such as AJ Bell YouInvest don’t seem to require that. I suspect folks will soon learn to tick the box regardless simply because most investors will have done some research on the fund, or already hold it (perhaps on another platform).

In summary, KIDs are designed to meet the needs of unsophisticated pan-European investors where little information might have been available to them previously. Whereas in the UK we are awash with information on trusts and open-ended funds to the point that a lot of investors are suffering from information overload. The KID just adds to it.

The information provided in the KID can be grossly misleading about the risks and returns that investors might expect. The document is the end result of the complex bureaucratic processes in the EU for devising new financial regulations, where those developing them seem to have little understanding of financial markets or investment and the end result is often a compromise between different national interests. The process is also heavily influenced by the large financial institutions such as banks that dominate the retail investment scene in much of Europe.

Financial regulation in the UK is not perfect of course, and we have the same difficulties that they are often written not for the benefit of investors but for market operators and intermediaries. We might just be able to do better. But we also need to push for improvements to the content of KIDs because we may still need to produce them to enable trading of investment trusts and funds across Europe.

It is though unfortunate that the cost of producing a KID will be significant and will be passed on to investors. Likewise the MIFID regulations brought in on the same date have resulted in major costs for stockbrokers. More regulation costs money and investors do not always benefit from it. One particularly disadvantage is that it deters new entrants into the investment world, i.e. protects the interests of the big boys from more competition. Financial regulations when devised need to be simple and low cost to implement and enforce. That is a long way from being the case at present. The PRIIPS regulations are a good example of how not to do it.

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

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Year End Review, the Future, RBS Requisition and New Year’s Honours

This time of the year is when all private investors who invest directly in the market should be reviewing their investment performance over the past year. If you can’t do better than the professionals (after costs) then you might as well let them manage your portfolio. So when it comes to the year end I work out the data and look at where I made and lost money (as a learning exercise).

Let me first explain that I have a very diversified portfolio and I simply aim to beat the FTSE-AllShare as a benchmark. It is diversified both in size of company and market sectors. This was the breakdown of my holdings recently:

AIM Shares: 37%
FTSE-100: 5%
FTSE-250: 24%
FTSE Small Cap: 4%
Funds/Trusts: 15%
Property Trusts: 6%
Unlisted shares: 1%
VCTs: 8%
Bonds 0%

 

The result was a Total Return of 22% for 2017, which compares with the FTSE-100 increase of about 7%, FTSE-250 of 14%, FTSE-AllShare of 9% and FTSE-AIM of 33%. Clearly I would have done even better to have invested solely in AIM shares but that would have meant an overall portfolio very concentrated on smaller companies (particularly bearing in mind that some of the Funds/Trusts and all the VCTs invest in smaller companies).

The overall portfolio dividend yield was 3.9%. The reason why this is so high is partly because the Venture Capital Trusts (VCTs) paid out large dividends, but these actually showed capital losses during the year – apart from a couple of AIM VCTs. That just shows how the market drove up AIM shares last year, because AIM VCTs are often tricky investments because of their propensity to take up IPOs. Other VCTs showed a preference to turn capital into tax free dividend income because of the rules they have to adhere to that stops them retaining cash and a desire to “recycle” capital so investors get more tax reliefs.

National Grid also used the “consolidation” trick to turn capital into dividends following a major disposal which affected the numbers slightly, but otherwise also lost value no doubt because of investors’ worries about the threat of nationalisation or more Government interference if Corbyn gets into power.

Lots of my big winners during the year were the most popular AIM shares – technology and internet stocks – I won’t name them for fear you’ll all be piling into them even more as seemed to happen in the last few days of 2017, and at risk of talking about my own “book” which will lead to recriminations when one or more come unstuck. But there were a few larger winners – Persimmon and Greggs for example – which were both big losers in the previous year. I sold Berkeley Homes at the start of the year which was a mistake although that was partly offset by investing in Telford Homes (an AIM stock of course). Apart from McColls (a convenience store chain), retail shares were out of favour so Dunelm was a big loser. Property companies did surprisingly well so my holdings in Segro, Tritax and TR Property Trust did better than everyone was forecasting for the year. I did invest in some investment trusts with large international exposure which helped the portfolio performance because of the fall in the pound.

Needless to say, it may be wrong to change one’s investment approach simply based on the results of one year, particularly when the market seems to be so buoyant in certain sectors. Is the market going to crash in the near future as some have predicted? Who knows – not me. Should I pile into more AIM shares that have been driven up by momentum traders? You can do that but I won’t because the chance of getting out at a decent price if a crash did occur in small cap shares is small. I still look at the fundamentals of companies and I have been limiting my exposure to some of the AIM shares in my portfolio because revenue growth can only be worth so much. Cash flow and profits are also important. I only try to hold AIM shares where the business has quality and a longer-term future. That way you can ignore short term fluctuations in the share price, and avoid big tax bills unless you trade only within an ISA or SIPP.

Some shares and sectors certainly look overvalued at the moment, but that is always the case. US stock markets are probably of more concern in terms of valuations than UK ones, but if the US crashed then so would the UK and other markets soon after – they are now globally synchronised. So I am holding a moderate amount of cash at present which probably reduced my portfolio performance last year to some extent. I’m just waiting for those buying opportunities, but they may not come any time soon. It’s a “bottom up” strategy rather than “top down” so if shares at attractive valuations appear, I’ll buy them.

One of the biggest news items in the last few days was the submission of a requisition for the appointment of a Shareholder Committee by ShareSoc and UKSA at the Royal Bank of Scotland (RBS) – a photo of ShareSoc director Cliff Weight outside the RBS offices is shown below.

RBS - Cliff Weight

This is of course the second year that such a resolution has been submitted for the RBS AGM. Last year it was rejected by them on what I consider spurious grounds. Let us hope they accept it this year because the ability to add resolutions to meetings (or requisition General Meetings as per the recent event at the London Stock Exchange, the LSE) is a fundamental element of shareholder democracy in public companies. If that part of the Companies Act is ignored it means directors can do what they want. The LSE had the good sense to accept the demand for a vote on the Chairman, let us hope that RBS do likewise.

Incidentally, the LSE directors and Mr Rolet, who they accused of being other than a team player, would do well to read a book I reread over Xmas – “How to Win Friends and Influence People” by Dale Carnegie. I read it first many years ago but had forgotten what it says (when my wife noticed I was reading it she said I should have read it 30 years ago and I had to admit I had done so). The first lesson in there is “Don’t criticise, condemn or complain”. But it’s a good read anyway, both amusing and well written, particularly if you are looking for some self-improvement.

To get back to the events at RBS, if Cliff manages to persuade RBS to accept the resolution, and can then persuade the Government to support the resolution (they have enough votes to swing the outcome) this will be a major achievement. It takes a lot of effort to pursue such campaigns as I know myself. I would suggest we should nominate him for an “Honour” if he achieves his goals – just go here for how to do it: https://www.gov.uk/honours

That thought came to mind when I was reading the New Years Honours List in the FT (not that I am in the habit of perusing the list but there was not much else to read over the Xmas holiday). One surprise was the award of an OBE to Suranga Chandratillake, for “services to engineering and technology”. He was a former director and founder of controversial company Blinkx (since renamed RhythmOne) – or as the FT said – a company whose market value has been volatile since its IPO in 2007. Mr Chandratillake remains on the board as a non-executive director having stepped down from being CEO some time before the furore over possible misleading stats reported by internet advertising companies blew up. Still public Honours may not be awards for success – just consider the award to Nick Clegg. I had better not say anymore otherwise I will be unlearning the lessons from the above book.

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

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