Hargreaves Lansdown and Fund Charges

There was a good article published yesterday by Phil Oakley of Sharescope on Hargreaves Lansdown (HL). Why are they so profitable a business when, as Terry Smith said, they seem to be in essence a “distributor” operating in a highly competitive field with few barriers to entry? The answer, apart from their high-quality customer service, is the level of charges they make on investment in funds (unit trusts and OEICS, not investment trusts which are treated as shares).

Investors in SIPPs via HL might be paying several thousands of pounds per year on larger portfolios (e.g. £3,000 on £1m and more on larger amounts), when investors would only pay £200 for a similar portfolio in shares. Other platforms also charge more for funds, but are substantially cheaper even so.

Why do they charge so much more for funds than shares? Phil questioned whether there is any more administration as a result.

But you can see why HL and other platforms promote funds so aggressively rather than direct investment in shares or in investment trusts (and bear in mind that there are usually equivalent investment trusts for most OEICs, often even managed by the same managers).

HL seems to be a company that it is better to be an investor in than a customer. Customers are suffering from the syndrome of buying something that they are sold that is in the seller’s interests, rather than standing back and deciding what they want, who they wish to buy it from and what price they wish to pay. In other words, investors are not “shopping around” for the best deal.

For that reason when HL adopted their new platform charges, I closed my account and moved my SIPP portfolio elsewhere. But it’s not a thing to be done lightly as it takes a lot of time and hassle to do so as disgruntled customers of Barclays are finding out. An example of the FCA not ensuring there is a competitive market by guaranteeing rapid transfers as they should be doing.

Now many readers might say, but I don’t have a large portfolio – just a few tens of thousands in value. And I get the same high-quality service for relatively little money. Firstly you need to bear in mind that overall portfolio charges are a significant drag on investment returns. As your portfolio grows, the bigger the drag.

HL may be vulnerable to losing their larger customers, who are clearly the most profitable ones, to competitors who could cream off the big hitters by various marketing tactics. Having a number of different stockbroking accounts, in general I find the administration is fine and they seem to compete on price to a large extent rather than facilities or service. Their focus is on attracting new investors who wish to start investing rather than converting existing investors from other platforms. Perhaps it’s the difficulty of persuading clients to move their accounts that inhibits them and reduces the competitiveness of the market for stockbroking services.

HL might therefore be vulnerable to regulatory change if the FCA tacked this issue vigorously and other platforms got their marketing act together.

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

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Audit Quality and the Caparo Judgement

There was a very good letter from Guy Jubb and Mark Solomon on the subject of the Caparo legal judgement in the Financial Times yesterday (6/2/2018). It was headlined “It is time the curse of Caparo was broken”. Here is some of what it said:

….the joint inquiry into Carillion by the parliamentary Work and Pensions Committee, and Business, Energy and Industrial Strategy Committee, must examine closely the little-known consequences of the Caparo judgment (Caparo Industries plc v Dickman [1990] 2 AC 605), which, in summary, ruled that auditors do not owe a duty of care to any one shareholder but rather to the body of shareholders as a whole, represented by the board of directors. The court decided that it would not be fair to visit what was viewed as indeterminate liability to investors for purely financial loss upon auditors and their firms. This all means that, as a practical matter, the auditors of listed companies are, in the normal course, immunised from the risk of being sued by investors for audit failure. It just never happens.”

The Caparo judgement overturned the previously assumed responsibility of auditors to the shareholders of a company and the general public to ensure that the accounts of a company could be depended upon. The judgement seemed to rely on the fact that shareholders have no contractual relationship with the auditors but only with the company who appoints them.

This judgement made it exceedingly difficult for shareholders to pursue auditors, and although there are possible “derivative” actions there are other obstacles that have been introduced over the years that reduce the potential liability of auditors. One is that they are now mostly not simple partnerships with the partners being individually and personally liable, but Limited Liability Partnerships. Secondly auditors write their contracts with companies and these now limit the scope of liability substantially – they frequently exclude liability for omissions that one would expect auditors to identify.

With the declining quality of audits, and the lack of competition between the big four audit firms, it is surely time to revisit the whole legal framework under which auditors operate. With companies often more interested in reducing audit costs than ensuring the accounts can be relied upon, one can see why and how the standard has been reduced over the years.

It’s not just Carillion that has shown how dubious are current audit standards but the problems in the banking crisis faced by RBS and HBOS were a direct result of lax audit reports. It also extends to numerous smaller companies – indeed too many to mention.

How to fix these problems? These are my suggestions:

  1. Auditors should have a statutory responsibility to the owners (i.e. the shareholders) in a company.
  2. Auditors should personally be liable for failings and not be able to hide behind LLP structures.
  3. Contracts between auditors and companies should be based on “model” contracts as laid down by the Financial Conduct Authority or the Financial Reporting Council, and drawn up based on the advice of investors.

I shall write to my Member of Parliament on this subject as this is something the Government needs to take in hand. I suggest readers do the same. How do you contact your M.P.? Simply go here for contact information: https://www.parliament.uk/mps-lords-and-offices/mps/

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

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Good News – Shares Are Getting Cheaper!

Yes the markets are plummeting, but that’s surely good news. It means you can buy the profits and cash flow that companies generate at lower prices! But the irrationality of investors and their tendency to follow the herd means they often do not pay attention to this good news.

The market turmoil at present is simply one of those sell-offs where investors think that sentiment has turned and it might be a good time to realise some profits. But the projections for the earnings of companies have not changed, nor for the dividends they might be paying in future.

The stocks that have been badly hit are those where the earnings are non-existent and the cash flow negative. In other words, those where growth in revenue is expected sooner or later to generate some profits. Or where speculators are playing a game of “pass the parcel” where they hope to sell to a bigger fool.

So here’s a few companies that suffered today of that ilk: Blue Prism (down 6%), Purplebricks (down 7%), LoopUp (down 7%), FairFX (down 7%), Wey Education (down 14%). These are not necessarily bargains yet as confidence in their future is everything when evaluating such businesses and confidence is fast evaporating from investor sentiment.

What should one do when the market is falling? One thing to bear in mind is that you can never know how far the market will fall, or when it might start to recover. Don’t try is my answer. Just follow the trend – the trend is your friend as the old saying goes (author unknown). In other words, you should not be buying when everyone else is selling because trends can persist for an unexpectedly long time. You need to wait until the market, and the individual stocks you are looking to buy, really, really do look very cheap on fundamentals. We are surely a long way from that point at present.

I shall wait to see if any bargains appear.

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

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Revenue Recognition, Patisserie Valerie, Utilitywise and Cryptocurrencies

Revenue recognition is a hot topic at present as folks have come to realise that this is a frequent cause of company accounts misrepresenting the true state of the business. Quindell and Blancco are two examples and I cover Utilitywise below. But first let me report on the Annual General Meeting of Patisserie Valerie (TIDM:CAKE) which I attended this morning (as a shareholder of course).

The company operates a chain of cake+coffee shops under the company name but they also have several other brands. However they seem to be concentrating on the Patisserie Valerie one in terms of new openings. This is a typical “retail roll-out” story where they just open more outlets – fixed costs do not increase in proportion so profits grow rapidly. They plan to open about another 20 stores per year at present. The company is run by Executive Chairman Luke Johnson who owns 38% of the company.

Having read the Annual Report I asked a question on revenue recognition because on page 16 it says “revenue recognition has been identified by the audit team as a significant risk”. Perhaps the auditors are now hedging their bets by putting that in all company reports but I found it rather surprising bearing in mind that I expected most customers would be paying cash in the cafes. Indeed the CFO indicated 80% of revenue is in cash. They do issue promotional vouchers but these are not recognised as revenue until used. However they do have some wholesale customers and franchise deals with companies such as Sainsbury where payments are delayed. This explains why they have significant trade accounts receivable at £12.3 million on revenue of £114 million. So I don’t think revenue recognition is likely to be an issue in this company.

Otherwise the AGM was fairly routine and we did get some cake at the end. There were about a dozen shareholders present in the City at one of their outlets. Luke Johnson is not a greatly impressive figure physically (first time I had met him) but answered questions openly. He noted profits were up 19% at £16.4 million. He said they opened 20 new stores and all were immediately profitable. Net cash was £25 million at the year end so they are well positioned for acquisitions if they arise, he noted. A couple of interesting questions from shareholders were:

  1. Is there any difficulty in attracting staff, particularly in London and the South-East. Answer: probably as hard as it has ever been, but they expect a lot of foreign staff to stay in the UK after Brexit and many are non-EU citizens anyway.
  2. Media have reported a possible acquisition of Gails, a similar chain (and partly owned by Luke Johnson I believe). Answer: cannot comment.

In summary, Patisserie Valerie is riding on the popularity of cake and coffee of late, but they are differentiated slightly from common coffee shops. They are also vertically integrated which keeps costs of the cakes low and as a result have good profit margins. Defending that position could be tricky but the business seems to be well managed.

Utilitywise (UTW), a reseller of utility power contracts, has had its shares suspended after failing to file accounts within the timescale required by the AIM market rules. To quote from the company’s announcement: “This delay is due to the volume of work still required to be completed by the Company and its auditor to cater for the proposed change in the Company’s revenue recognition policy, as announced on 17 January 2018. This work includes amendments to the Company’s financial reporting systems in order to analyse energy contract data in accordance with that new policy, alongside associated work by the Company’s auditor, for the audit of its results for FY17 to be completed.”

Now I don’t currently hold this company’s shares but I did briefly from December 2013 to July 2014. The more I learned about the way revenue and profits from contracts entered into that covered future periods were recognised, the more concerned I became. Revenue was still reportedly growing rapidly in 2014 but I sold at about 260p. The share price recently was near 40p.

In my book, revenue and the associated profits from long-term contracts should not be recognised until the cash comes in. But that’s not the way accountants like to handle matters at present. Part of the difficulty lies in costs expended in the short term to obtain or develop the contracts so matching costs with revenue, a basic accounting principle, is a problem.

Lastly I think it is worth mentioning cryptocurrencies, initial coin offerings, bitcoin and blockchain technology. These are all hot subjects that I do not think I have covered before which is probably a gross omission.

Blockchain technology is interesting. It’s basically an “open ledger” which might have many applications, although whether it is really any good for really high volume transaction processing seems to be in doubt. Many banks and other financial institutions seem to be looking at it but it is not altogether clear why they need it (are not existing systems and software adequate enough? Perhaps they are just a bit archaic?). It may be lower cost and simplify development but it potentially has great weaknesses.

For example, Coincheck, the “Leading Bitcoin and Cryptocurrency Exchange in Asia” as they style themselves, recently suffered a hack that meant $500 million has disappeared into the hands of the perpetrators. They have promised to reimburse affected customers but it seems highly unlikely that they have the financial backing to do so.

This is not the first such time this has happened. Another case was that of MtGox which became bankrupt after a similar fraud. So it seems bitcoin systems are not as secure as one might have hoped.

One reason internet fraudsters like payments in Bitcoins is allegedly because they cannot be traced. So does that mean there is no audit trail so one cannot trace where the funds come from and where they go to? This is a major defect in any transaction system which suggests to me that Bitcoins and other similar currencies based on blockchain technology should be promptly regulated by all countries as soon as possible. There may be a need to have a “virtual” currency not controlled by any one Government, but unless it is secure with proper audit trails on its movement, it is not fit for purpose.

The Financial Conduct Authority (FCA) should be looking at this area and pronto before the wide boys of the financial world exploit gullible folks and fraudsters take advantage of its defects.

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

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Government To Review Share Buy-Backs

The BEIS Department of the Government has announced a review of share buy-backs. That’s where the company buys its own shares in the market, a practice that used to be illegal but is now very widespread.

Business Secretary Greg Clark said: “…there are concerns that some companies may be trying to artificially inflate executive pay by buying back their own shares. This review will examine how share buyback schemes are used and whether any action is required to prevent them from being abused.”

If a company buys back its shares, then it will increase the earnings per shares (EPS) because the same profits will be spread over fewer shares. But EPS is often an element in the calculation of performance related bonuses, e.g. in LTIPs. So effectively management can earn bonuses by simply deciding to buy back shares rather than really improving the underlying performance of the business.

Obviously cash has to be used to buy back the shares, and another concern is that this is money that should be used to develop new products, services or markets. In other words, it contributes to the lack of investment in the UK economy. In extremis companies can borrow money (i.e. gear up) to provide the funds to cover the buy-back which increases the risk profile of the company.

There is also the suspicion that some companies undertake large scale buy-backs to support their share price, often encouraged by institutional investors who wish to exit. The directors always deny this, but one can see the sub-conscious motive to “clear-up a share over-hang” that may be present. In practice, share buy-backs may benefit shareholders who are departing more than they benefit shareholders who remain.

In theory, if a company cannot find a good use for surplus cash, i.e. cannot reinvest it in the business profitably, then buying in shares where the per share intrinsic value of the company is more than the market share price should make sense. But determining what is the “intrinsic value” is not at all easy.

There are also tax issues to consider. Some investors think it’s best to retain the cash in the business because paying it out in dividends might incur more tax, and sooner, than the capital value growth that might otherwise be obtained.

You can see there are many complex issues around this topic that could fill a book, or at least a pamphlet. But here are some comments on the approach I take:

  1. I always vote against share buy-backs unless there are very good justifications given by management (and that’s about 1 in 20 votes in practice).
  2. The only general exception I make is investment companies (e.g. investment trusts) where it does make logical sense and can be used to control wide discounts.
  3. I prefer management to reinvest in growing the business if they have surplus cash (and as I rarely invest in no-growth businesses, you can see why the above rules are easy to apply).

If the advisors to the Government determine that share buy-backs are being undertaken for the wrong motives, what could they advise the BEIS to do about it? Reading the minds of directors about their motives for share buy-backs will not be very practical. If they simply wish to stop the abuses related to incentive schemes they could insist that all such schemes (including all share options) should be adjusted for the buy-back – they often are not at present. But would it not be simpler just to revert to the old regime and outlaw them except for investment companies? I do not recall it created any major practical problems.

If a company’s shares consistently trade below “intrinsic value” then someone will buy them sooner or later – after all many people believe in the perfect market hypothesis and it’s probably true to a large extent – particularly with large cap companies where share buy-backs are the most common. So simply banning share buy-backs should not create significant problems.

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

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VE and Pre-Packs

There was an interesting report in today’s FT on the case of Ve Interactive, a UK company once allegedly worth more than $1 billion (at least they had several hundred employees) which went into administration after making heavy losses. It is alleged that CEO and founder David Brown mismanaged the company and he has subsequently be made bankrupt.

The business was taken over by a consortium of investors (including Douglas Borrowman and Mark Pearson) some of whom became directors before it went into administration. It was subsequently sold quickly to those directors via a pre-pack (for £2 million).

But the administration (by Smith & Williamson) has been challenged in court and they have been removed by the court. Mr Brown and two former members of the consortium mounted the challenge based on the claim that the administrators were “completely blind” to the conflict of interest in selling the business to the directors. They also claim the sales process was mishandled and bidders only had one day to make an offer. They say there was no chance of a meaningful bid being made because of insufficient information being provided to potential buyers. Ve Interactive is now trading as “VE” and is owned by Ve Global UK Ltd.

At least that’s the gist of the story so far as one can understand such complex events.

In essence this is a typical example of a pre-pack administration which I have commented on many times in the past. A business is sold in extreme haste, often to related parties as in this case. The process happens so quickly that there is no chance of adequate marketing of the business to get a fair price. The administrators can ignore anyone but their chosen buyer and deter them by restricting information and giving them little time to raise finance or adequately consider the matter.

In summary, pre-packs are ethically dubious, legally corrupt and should be outlawed as soon as possible. As I said only recently in an article about events at Carillion: “Regrettably in the UK, insolvency law seems to have been devised mainly in the interests of insolvency practitioners and bankers. It is time for a complete reform of the law and practices in this area.”

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

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More on EMIS Profit Warning

A few days ago I commented on the announcement by EMIS Group that warned about a failure to meet customer service levels and a possible hit to profits as a result of up to £10 million. As I said at the time, I wrote to the Chairman and asked several questions. Today I received a response by letter from Peter Southby, CFO. He has been there since 2012 it is worth noting.

The letter was the typical “brush-off” that individual investors tend to receive – for example it commenced: “I am afraid we are not able to respond to questions from individual shareholders on this matter for standard reasons around customer confidentiality and commercial sensitivities”. So I phoned him up and reassured him I was not seeking inside or price sensitive information. He then proved more amenable. This is what I learned:

The failure was to meet service level agreements with NHS Digital for the GP software (EMIS Web). The current contract was signed in 2014 but there was a previous similar contract.

EMIS discovered the problem themselves, following a review of customer services, rather than the client reporting it. The issue is a “low level” service issue, and not a critical item to the customers who have not been impacted significantly. The problem was not known to senior management until it was recently reported (certainly the CFO was not aware of it). It is not currently known how long the failure to meet contract terms had been running. They are working to get back within the contract terms as soon as possible. As regards the past failure and associated financial liability, it is possible the customer will accept an alternative rather than a cheque – for example, provision of software enhancements. But that is subject to negotiation.

EMIS have an active “user group” and the problem has apparently been discussed with them already.

In my original note I suggested auditors KPMG might have been at fault for not picking up this problem in their last audit, but it does sound as though that might not have been possible. However I suggest that is a question to be revisited later and it still leaves the issue of major risks not being noted in the Annual Report.

In conclusion, the problem may be less serious than first apparent, although there is still a risk in this kind of situation that more issues may be discovered the more investigations are performed. Will have to wait and see for the moment.

One thing I am certain about though, which is why I like the company. The GP end-users would hate to switch to another software product. Admittedly EMIS will have to negotiate their way out of this difficulty with NHS bureaucrats rather than end-users but when an on-going relationship of some years standing is in place, then some horse trading is the usual outcome. I’ll have to ask my GP what he knows about this problem next time I see him.

Just one final point: If you get the kind of response I got, then it’s always worth a phone call. Personal contact can make the difference.

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

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