Halma and Return on Capital

Yesterday I talked about Diploma (DPLM) and their calculation of adjusted return on capital. This morning Halma (HLMA) published their half year results and they also have a strong emphasis on return on capital, but in this case they call it “ROTIC” (Return On Total Invested Capital). This was down slightly at 13.4% and they define it as Adjusted Profit After Tax divided by Total Invested Capital. The latter is shareholders funds, plus retirement benefit obligations, less deferred tax assets, plus cumulative amortisation of acquired intangible assets plus historic adjustments to goodwill. This similar to the Diploma definition but it is not clear whether it is exactly the same and they call it something different.

As almost every company now reports “adjusted” figures of one kind or another, and analyst forecasts of earning are also usually based on adjusted profits, would it not make sense to have some standard for such data? That’s in addition to the current “statutory” figures which are mandated by the Financial Reporting Council (FRC).

Some of these adjustments, like the ones above in the case of Halma to calculate return on capital make a lot of sense if you wish to obtain a somewhat different view of a company’s performance. But some do not – for example I commented negatively only recently on the figures reported by National Grid.

The FRC would be the best body to set such standards, although they appear to have avoided doing so in the past. Now it just so happens I am attending a meeting with the FRC organised by ShareSoc/UKSA later today and if I get the opportunity I will raise this issue. It would certainly help investors if companies, financial analysts and information web sites reported such adjusted data in a consistent manner, would it not?

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

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Diploma (DPLM) and Return on Capital

Diploma Plc, a supplier of specialist technical products, issued its preliminary results for the year to the end of September today (20/11/2017). This company may not be a household name and hence can fall under the radar of investors. But it has demonstrated a consistent track record in recent years. Today was no exception. Adjusted earning per share were up 19%, and revenue was up 18%, although a significant proportion of the improvement was down to currency movements (they are a very international business and the falling pound has no doubt helped). The share price has risen 10% on the day at the time of writing.

But why do I like this company? Apart from the track record, the directors have a strong focus on obtaining a good return on capital both from their on-going businesses and from acquisitions. But which measure do they use (Return on Equity – ROE, Return on Assets – ROA, or Return on Capital Employed – ROCE. These are all useful measures, and you can no doubt look up their definitions on the internet. But they use none of the above. They actually report “Return on Adjusted Trading Capital” – ROATCE. This they report as improved to 24% (their target is to exceed 20% which they have beaten in the last five years – that’s certainly the kind of figure I like to see).

How do they calculate this figure? I quote from the announcement: “A key metric that the Group uses to measure the overall profitability of the Group and its success in creating value for shareholders is the return on adjusted trading capital employed (“ROATCE”). At a Group level, this is a pre-tax measure which is applied against the fixed and working capital of the Group, together with all gross intangible assets and goodwill, including goodwill previously written off against retained earnings.”

Personally, I don’t think one measure of return on capital is particularly better than another. Return on Assets is good enough for me although it certainly helps that the company has added back write-offs of goodwill from past acquisitions to save one working it out for oneself. For a company that does repeated acquisitions, these “disappearing” assets are worth bearing in mind. Return on Equity might be considered by some as the most important for equity investors, but using that as a target by management can result in risky behaviour such as gearing up with debt. Bank directors were often keen to talk about that number before the 2008 crash.

Why is return on capital so important? Because when one invests in a company, you are investing in the expectation of a future return. How much they can generate in returns from the assets under their management is a key measure (that’s ignoring the profits from investment from getting a greater fool to buy your shares in a game of “pass the parcel”). I learned this was the best measure of the quality and performance of a company when I went to business school, and I never forgot it when I ran a business. In the modern world, it can be easy to borrow capital and blow it on expansive plans. This can help the management increase their salaries. But for equity investors, it dilutes your returns and you lose the benefit of compounding the retained profits.

The best, and shortest book, that explains this in layman’s terms is Joel Greenblatt’s “The Little Book That Beats The Market”. He uses return on capital (as he defines it) in a calculation of a “Magic Formula” for success. But of course using a simplistic formula has its dangers. If everyone followed it, prices might be driven up to unreasonable levels on the stocks chosen by such a formula. In addition I just looked at the stock list that Stockopedia suggests would be “buys” using the Magic Formula. It results in a mixed bag of shares. For example, it includes Safestyle which I also own when that company’s share price has been falling of late due to concerns about the retail market for large general merchandise items (they sell replacement windows). It might be a “BUY” now but it could also be a share where you could wait a long time for it to return to favour. So the moral is, use return on capital as one measure of the merit of a company, but look at other factors also. In addition, bear in mind that sometimes the market can favour other companies, such as those with little profits in a go-go bull market, or those with massive, if underutilised, assets in a gloomy bear market. So the Magic Formula is best applied to a basket of shares and you might need patience over some years to see the benefits realised.

Lastly, financial numbers do not tell you everything about a company. The historic numbers can be inflated by clever, or false accounting. And they can ignore major strategic or regulatory challenges that a company faces that might not be reflected in historic numbers.

But a company whose return on capital is low is certainly one I like to avoid. It is also helpful when the management talk about return on capital as having importance in their business strategy, and Diploma certainly do that. I consider that a positive sign because if they stick to it, then it should ensure the overall financial profile of the company remains positive and that profits will grow.

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

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Should You Invest In Art?

Following the sale of a Leonardo da Vinci painting for $450 million, those readers who like to speculate might think that investing in art may be worth trying. This was a painting that sold for only £58 in 1958, perhaps because its authenticity was doubted and it had been “overpainted” in some areas. It’s now been restored but it’s far from perfect even so.

It is now the most expensive painting ever sold. Back in 1987, the most expensive painting ever sold was “Irises” by Van Gogh for $54 million (Wikipedia has a list of the most expensive paintings if you wish to follow how these blockbusters have gone up in value, but it is not a smooth progression). Potential buyers of these rare, or unique, paintings which will fetch stratospheric prices should however best leave this market to professional dealers.

But is investment in lower price paintings sensible? Fine art has steadily increased in value so in the long term you can probably expect to beat inflation. But particular genres can go in and out of fashion which could easily add or subtract 50% of the value. In addition you have high trading costs. Auction costs can add 30%, and the market is hopelessly illiquid. Making a sale even at an auction can be a hit or miss affair. If you buy paintings direct from a dealer and are paying “retail” prices then it may take you years to recover the value when you sell because of dealers’ high mark-ups (retail prices are typically higher than auction prices).

The best quote on this subject was probably this one from Lew Grade: “When a little girl asked me what two and two make, I’m supposed to have answered – it depends whether you’re buying or selling”.

In summary if you wish to buy art to hang on your living room wall, then OK. You may gain some tax advantages as it will be considered a “chattel” if you ever come to dispose of it. But as an investment, art is far from the best choice.

For more information on the valuation of paintings (written when Van Gogh’s Irises was the most expensive painting), see http://www.panvertu.com/valuation.htm

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

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Preparing for Brexit

Apparently MPs on the Public Accounts Committee are very concerned that a new Customs Declaration Service will not be ready in time for Brexit – at least this was in a report in the Financial Times, assuming it is not another of their scare stories. The timescale is indeed somewhat tight to get the new system in place before the likely Brexit date, particularly if one bears in mind that many Government IT projects overrun.

Inability to process export declarations quickly could result in massive queues of traffic awaiting clearance. I recall a previous suggestion that lorries might be backed up along the M20 as far as the M25 which would certainly personally inconvenience me.

But I have some experience of implementing major IT systems for HMRC (or Customs and Excise as it then was) as I was involved in the implementation of the VAT system back in 1973 (when we joined the EEC at the same time). This was a project commenced two years earlier. It had to go operational on time, and it did so without a hiccup. One of the more successful events in my IT career although I only played a minor part in it. The key point I wish to make is that fixing a date when it had to go live concentrated everyone’s minds on the project, and it ensured the best expertise was available to deliver it. The VAT implementation project, which affected not just tax collection work by the Government but also almost all UK businesses was one of the biggest and most important Government IT projects ever completed.

Now when Mrs May decided to fix a specific date for when we will be leaving the EU, to my mind this was a wise thing to do. It will focus those responsible for the supporting systems to enable this to happen smoothly (whatever the nature of the deal, if any, finally agreed with the EU for post-Brexit trade arrangements) if a date is fixed now.

But yesterday the Daily Telegraph ran a front-page story on the “Brexit Mutineers” who were planning to revolt against a fixed date, and as a way to undermine Brexit it was suggested. Lots of other news channels covered the story and one of the mutineers, Bob Neill my local MP and one of the “mutineers”, appeared on television to suggest it was simply the normal democratic scrutiny process. The revolters also signed a letter printed in today’s Telegraph saying a fixed date was too inflexible. There may need to be last minute extensions to conclude a transitional deal. I beg to differ. A fixed date will concentrate the minds of both British and EU Brexit negotiators, which could be of course the reason for Mrs May’s decision.

On both political grounds, and to help those implementing the required systems, fixing a date is the right thing to do in my opinion.

Meanwhile the FT has an editorial supporting the “no fixed date” revolt, and they also published several letters today opposing Brexit. All I can do is yawn at their persistence in ignoring the realities of the situation.

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

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Abcam AGM, Cambridge Cognition, Ultra Electronics, Wey Education and IDOX

Yesterday I attended the Annual General Meeting of Abcam (ABC) in Cambridge as I often do as I have held the stock since 2006. Share price then (adjusted for consolidation) was about 50p and it’s now about 950p so I like most investors in the company, I am happy. Alex Lawson will be doing a full write-up of the meeting for ShareSoc so I will only cover a few points herein.

One shareholder expressed concern about the rising costs. The company is clearly making heavy investments in new infrastructure and more management. Although revenue was up 26.5% last year, earnings per share were only up 11.8% (unadjusted) and operating margin has been falling. Also Return on Capital Employed (ROCE) has been falling – only 12.3% last year when it used to be in the high teens.

Apart from opening a new building next year, they are implementing an Oracle Cloud software solution to replace their historic purpose-built legacy software systems. The total cost of that project is £44 million (see page 23 of the Annual Report) when profits last year were only £42 million post tax. In other words, all of last years profits could be taken to be consumed by this project. This project has been running for some time and I have asked questions about it in previous years. This year I asked: “is the project on schedule and on budget”. I did not get a straight answer. But it was said that initial cost estimates have expanded, and additional modules been added (for example warehouse management). It should “go live” in the current financial year. From those and other comments made, I got the impression that this is a typical IT project that is too ambitious and costs are escalating while delays have arisen. Those “big bang” IT projects rarely go according to plan, but management are often suckers for them.

Now it may be arguable that older systems need replacing (for example, the CEO mentioned it was impossible to bill in Swiss francs that at least one customer would prefer), and maintaining old code was clearly proving to be difficult. The massive investment in this area alone may be justified by the company’s ambitions to “double the 2016 scale by 2023 by investing in operating capabilities” as the CEO mentioned. The expectation is that growth will improve revenues and hence margins in due course.

One more way that costs have been rising is increased pay for management. CEO’s pay alone up from £614k to £1,378k in the last year (“single figure remuneration). In addition, I commented negatively on the fact that the LTIP target had been adjusted for the “scale and complexity of the transformational programme” of the new ERP system implementation, i.e. costs are much higher than expected so the LTIP target has been made easier to achieve!

At least Louise Patten (acting Chairman now after departure of Murray Hennesey for a proper job, and Chair of the Remuneration Committee) admitted later that LTIPs are often problematic but institutions like them. LTIPs at Abcam have rarely paid out, and management at many companies seem not to value them highly. There are better bonus scheme alternatives.

I also spoke briefly to a representative of Equiniti, the company’s registrar, about the difficulty of voting electronically. He is to look into it. Amusing to see the company slogan on his business card is “Our mission is making complex things simple”, exactly the opposite of my experience!

In the morning I also visited Cambridge Cognition (COG) who have offices in the village of Bottisham east of Cambridge. Although their offices are in what appear to be wooden huts, they are well furbished. The company specialises in cognitive health (brain function). Sixty per cent of its revenue comes from clinical trials for pharmaceutical companies, thirty per cent from research institutes and academia and ten per cent from healthcare and consulting.

On clinical trials they do about 15 deals a year so by their nature they are lumpy one-off deals. Total revenue was £6.8 million last year. Before last year revenue was flat but it grew last year and is forecast to grow this year.

A lot of pharma companies are actively researching alzheimers and other degenerative brain diseases, and developing products to assist – as the population ages such diseases are becoming more prevalent. Cambridge Cognition’s technology relies on historically well validated studies. The company provides a lot of consulting support in clinical trial sales.

Such deals include 30 to 40% of software which is billed and paid for on normal 30+ days terms, with the services paid for as provided. One issue that arose is that their accountants are likely to require them to change so as to allocate the software revenue over future periods due to IFRS 15 because they host the software. This is the same problem that Rolls-Royce have tripped up on, and it is also an issue at Ultra Electronics (ULE) according to a report in the FT yesterday. That company also issued a profit warning on Monday and the share price fell 19.5% on the day. I used to hold it but not of late. The FT writer suggested it was time to “exit”. Cambridge Cognition did suggest though that they would not need to restate last years accounts, and the change might actually smooth their revenue figures. IFRS 15 is an important correction to historic aggressive revenue recognition policies in some companies.

Otherwise Cambridge Cognition have some interesting technology – for example using smart watches to monitor brain function during the day, and using speech recognition to perform analysis. Whether these can be turned into profitable markets remains to be seen. One of the original ideas in the company was to provide their software on i-Pads for general practitioners to use in diagnosis but that never took off due to changes in purchasing arrangements in the NHS who of course are notoriously difficult to sell to (and budgets of late for technology seem to have been cut). If anyone wants more background on Cambridge Cognition you are welcome to contact me.

A few weeks ago I purchased a minute number of shares in Wey Education (WEY). Minute because although it looks an interesting business I thought the share price was way too high on any sensible fundamental view. This morning the company announced a share placing to make an acquistion. This will be at 22p which is a 33.3% discount to the price on the 14th November according to the company. Clearly advisors and institutions took the same view as me on the previous share price. Has the share price collapsed this morning as a result? It’s down but not by much so far. Wey Education does look like one to monitor (which is why I bought a few shares) but I think I’ll stand back from the speculation for the present while the market is so twitchy.

This looks like one of those hot technology stocks that are all the rage of late (the company provides education over the internet as an alternative to school attendance). But investors are clearly getting more nervous about many of those stocks in the last few days – it’s no longer “keep buying on momentum” as some share prices have fallen back from their peaks (Abcam is one example), so it’s now sell, sell, sell. And if a company indicates that the outcome for the year will not be as good as the optimistic broker forecasts suggest, as IDOX did mid-afternoon yesterday, then the share price gets hammered. Announcements mid-afternoon of this nature are never a good idea. Interesting to note that Richard Kellett-Clarke is to remain on the board after all as a non-executive. He was previously CEO. That might inspire more confidence in the business as these kinds of hiccups did not occur during his regime.

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

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A Quick Guide to New Issues, SMRs, Car Market and Brexit

In today’s Financial Times (11/11/2017) Neil Collins gave a quick guide to new issues which is worth repeating. This is what he said: “Do not buy into an initial public offering if most of the capital raised is going out of the business, or if it replaces existing debt (because the capital has already left). Do not buy if private equity is selling. Do not believe any forward-looking statements, because if the prospects really were that good, the vendors would wait and get a higher price. Do not buy any share that has been listed for less than a year. You will miss some bargains but you will avoid many more disappointments. Leave it to the professionals to lose other people’s money.”

Those are wise words indeed. He also made some ascerbic comments on small nuclear power stations which he says have been rebranded as “small modular reactors” (SMRs) to make them less scary. Rolls-Royce, who have produced such reactors for submarines, have touted them as a potential future business growth area for several years, but the FT’s in-depth review of the subject last week suggested that they are not likely to be put into production any time soon. Meanwhile the share price of Rolls-Royce is still below where it was in 2014.

Neil Collins also commented on the car market. You probably don’t need to be told that new car sales have slumped. The share prices of car dealers are cheap as chips and even my shares in Auto Trader are down substantially this year. Indeed one could apply Neil’s comments about IPOs to the company although it has taken a couple of years to reveal that the debt when listed is handicapping the company now. The car market is inherently cyclical which is one reason why car dealers are normally not valued highly, and they also show low barriers to entry with the car manufacturers controlling the market to a large extent and limiting the profits that dealers make. But Auto Trader is similar to Rightmove in the property market. High margins, dominant market position and a business with great network effects with the result that competitors find it difficult to muscle in on their market. I think I’ll stick with it for a while yet.

I am not convinced that we have reached “peak car” as some have suggested. There seem to be more cars on the road than ever although traffic volumes have slowed in London where most such commentators live. But that is as much about political policies that have limited road space and caused congestion, mostly irrational, than car buyers desires. Another good analysis in the FT recently was about how “green” various car types actually are. On total life emissions, some smaller petrol/diesel vehicles can beat “all-electric” cars. How is that? Because the manufacture and decommissioning of electric vehicles generate large emissions, and producing the electricity for them often does also.

With all these plugs I just gave for the FT, it is unfortunate that it coninues to publish such tosh about Brexit. Most of their writers predict the financial outcome will be calamitous. Whether that will be the outcome or not, I don’t have the space to provide a full analysis here, but most people who voted for Brexit did not consider the financial issue as conclusive. Consider an American colonialist in the year 1775, before their declaration of independance. No doubt with an economy very reliant on trade with Great Britain many people would have counselled against leaving the protection of their parent country. Did that deter them? No because they valued freedom more highly. They wanted control over their own affairs including that over taxes, and not to be ruled by a remote and undemocratic regime where they had minimal representation. That is the analogy that all the remainers should think about.

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

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National Grid, Johnston Press, Crown Place VCT, Lloyds Bank, LoopUp and Brexit

I had a busy day yesterday, but let me first comment on the news today. National Grid (NG.) published their half year results this morning. They reported “Adjusted operating profit, excluding timing up 4%….” but statutory earnings per share were down by 12%. What exactly does “adjusted for timing” mean? I have no idea because the announcement does not explain it in any sensible way. For example, it says under “UK Timing”: “Revenues will be impacted by timing of recoveries including impacts from prior years”. Why are these revenues not being booked in the relevant period? Why are they not being recognised as revenues in the period concerned? Looks like a simple “fudge” to me as “adjustments” to reported figures in accounts often are. Many analysts seem to have a negative view of the stock, and I am coming to the same conclusion. I sold some of my holding in the company this morning.

I have previously mentioned the requisition of an EGM at Johnston Press (JPR), but the company has rejected this on the basis that it is “not valid”. It seems this is because the shareholder who requested it holds their shares in a nominee account (i.e. are not on the register). Yet another example of the obstruction caused by the use of nominee accounts. Changes to the law in this area are required to fully enfranchise all shareholders. See the ShareSoc Shareholder Rights campaign for more information: https://www.sharesoc.org/campaigns/shareholder-rights-campaign/

Yesterday morning I attended the AGM of Crown Place VCT, managed by Albion Capital. No excitement there. Just a competently managed VCT and a well run AGM with a presentation from one of their investee companies (PayAsUGym) who have developed an innovative business selling gym sessions. Crown Place made a total return of !4% last year and currently provide a tax free dividend yield of 6.9% which is covered twice by earnings. The expense ratio is 2.4% which is certainly better than many of the VCTs I hold. Previously this company had a strong focus on “asset-based” investments but they are now restricted by the new rules for VCTs so they are moving into more “exciting” fields. There are also concerns about further rule changes or removal of tax reliefs in the budget next Wednesday. Investors in tax incentivised vehicles seem to be getting nervous.

After lunch with representatives of AGMInfo, I filled an hour or so before the ShareSoc AGM by dropping into the Lloyds Bank legal action nearby which I have mentioned in previous blog posts. On the witness stand was former CEO of Lloyds TSB Eric Daniels being cross examined by the littigants QC. He gave a confident performance and was clearly well prepared. He said he was “bitterly disappointed” over the need to raise £7 billion in capital and was also disappointed that they would end up more highly capitalised than other banks. It was clear from his other comments that there was a certain momentum to go through with the deal (the acquisition of HBOS) and that they did not revisit the benefits of the transaction at every turn (e.g. as more information came out of the due diligence work for example).

He disclosed that in a conversation with the FSA there were real concerns that they could lose the vote of shareholders. This could be because there were views that HBOS could remain independent, although the Government had already indicated that it was promptly going to be nationalised if no rescue deal could be done; and because Lloyds TSB shareholders might vote against it.

The case continues. Lloyds Bank and the former directors continue to say that the claims have no merit of course.

It was then onto the ShareSoc AGM. Again no great excitement there. Mention was made of a possible merger with UKSA and as a former director of both I spoke in favour of that. Spreading the fixed costs over two organisations of a similar size makes a lot of sense. It should never have been necessary to set up a rival organisation to UKSA, but interesting to note that ShareSoc has more members now so my efforts in recent years were not in vain.

The ShareSoc AGM was followed by one of their company presentation seminars. Of interest to me (being current holders) were the two by LoopUp (LOOP) and Ideagen. I reported on Ideagen recently on coverage of their AGM so will only cover LoopUp herein. The presentation by their joint CEO Steve Flavell was slick but it was more a sales pitch for the product/service to customers than one to investors. The issue of them having two joint CEOs was raised in a question later.

The emphasis was on the simplicity of the service, so anyone could take it up easily and quickly. This is the major USP as there are lots of other conferencing products around. Most interesting was his explanation that they leapfrogged the “chasm” by ignoring the early adopters (who often like techy products) by aiming straight for the “mainstream majority”. His reference to “Crossing the Chasm” is from a book of that name by Geoffrey Moore which is essential reading for all sales/marketing executives in the software field, or investors in early stage technology companies likewise. Just had a chat with an Uber driver about this book – he has a degree in marketing – that’s the modern world for you. It will be a great shame if Sadiq Khan manages to put Uber out of business – might miss out on intelligent conversations with cab drivers. I read the book when it first came out back in the 1990s and Mr Flavell had read it also. I highly recommend the book. LoopUp is clearly a sales/marketing driven organisation but the technology is sophisticated enough to make it all look simple.

On the current valuation, the company has obviously a long way to go to grow into that valuation. Questions were raised about whether growth could be accelerated (revenue only up 39% in 2016m and 44% in the interims this year). But I expressed scepiticsm on attempts at a faster growth rate to Flavell after the meeting.

The Financial Times continue to publish anti-Brexit stories and editorial every day. My letter to the editor on the dubious bias, which they published, has obviously had no impact whatsoever. Tim Martin, CEO of JD Wetherspoon, had a lot to say about the subject of the impact of Brexit on food costs in his latest trading statement. He accused the media, and the Chairman of Sainsburys and that of Whitbread, and the head of the CBI, for completely distorting the facts. Rather than food prices rising after Brexit, he suggests they will fall. For his arguments see:

https://www.investegate.co.uk/wetherspoon–jd–plc–jdw-/rns/fy18-q1-trading-update/201711080700068513V/

My conclusion is quite simply that some foods might become more expensive, others might become cheaper, and home-produced products might also be cheaper; plus the Government might be able to save a lot of money on contributions to subsidising inefficient farmers. But that of course means that food buying habits might change as consumers react to price changes. Is that a bad thing? Readers can ponder that question.

Whether the Chairmen or CEOs of public companies should be making comments on essentially political issues, one way or the other, is also a question to consider. I suggest that might best be left to bloggers like me. Sainsburys and Whitbread (Costa, Premier Inns) might find they disaffect half their customers while having minimal impact on public opinion.

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

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