The Market, Dunedin and Standard Life Smaller Companies Merger, and Aston Martin IPO

Is it not depressing when you go away for a week’s holiday and your portfolio falls every day in that time? I do monitor any exceptional movements while on vacation but try to avoid trading. It just seemed to be a general downward trend and reviewing the movement over that week my portfolio is down 1.73% while the FTSE All-Share is down 1.72%. So that is what I had already surmised.

Those stocks that seemed to have become overblown did fall and there were some like Scottish Mortgage Trust (SMT) were hit by specific news – in their case the events at Tesla. But the fall in my portfolio last week was less than it went up the previous week. I feel not quite so depressed now I have done the analysis.

Anyway, I am back from holiday now and on my desk is a proposed merger of Dunedin Smaller Companies Investment Trust (DNDL) and Standard Life UK Smaller Companies Investment Trust (SLS). I need to take a decision on this as I hold the latter.

DNDL is smaller than SLS and following the merger of DNDL’s manager, Aberdeen Asset Management, with Standard Life the merged manager now has two trusts with a similar focus. SLS has a superior performance record – 100.7% net asset value total return versus 68.9% for DNDL over the last 5 years. The merged trusts would be managed by Harry Nimmo who has managed SLS for some years.

The directors argue that the merger makes sense because it will result in reduced on-going costs and improved liquidity in the shares, although they don’t quantify either claim. There is no immediate change proposed to the fund management charges on SLS. DNDL will be paying the costs of both parties if the merger goes through.

It no doubt makes sense for the manager to merge these trusts. Not much point in having two trusts in the same stable with a similar focus and they will save on management costs. It also makes some sense for DNDL holders but does it for SLS shareholders?

Enlarging a trust or fund can degrade future returns particularly in small cap funds. This is because buying larger quantities of smaller company shares is more difficult and exiting is also difficult. In other words, the manager may find they cannot be as nimble as before. Alternatively the number of companies in the fund has to grow and we surely know that this is a recipe to reduce returns as there are only so many “good ideas” out there. The more companies in a portfolio, the more likely it is to approximate to a tracker fund.

Therefore, I think I will vote against this merger for that reason.

But what alternatives were there for DNDL shareholders? The company could have changed the manager to avoid the conflict of interest. Or simply wound up if it was too small to be viable. Perhaps a wider international focus when SLS is UK focused would be another alternative.

Luxury car maker Aston Martin is to float on the market. I agree with Neil Collins comments in the FT this weekend – “never buy a share in an initial public offering”. He suggested those who are selling know more about the stock than you do. Car companies, particularly of niche brands, are notoriously tricky investments. Aston Martin has been bust as many as seven times according to one press report. As Mr Collins also said “The private equity vendors are dreaming of a £5 billion valuation for a highly geared business with a decidedly unroadworthy past”.

Car companies exhibit all the worst features of technology businesses. Product reliability issues (which was a bugbear for Aston Martin for many years), very high cost of new model production, Government regulatory interference requiring major changes for safety and emissions, competitors leapfrogging the technology with better products, and sensitivity to economic trends. In a recession few people buy luxury vehicles or they simply postpone purchases – so it’s feast or famine for the manufacturers.

There can be some initial enthusiasm for companies after an IPO that can drive the price higher but the hoopla soon fades. Footasylum (FOOT) was a recent example but McCarthy & Stone (MCS) was another one where investors found that the market proved more challenging than expected.

Resist the temptation to buy IPOs!

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

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Return Versus Risk and Tips from Terry Smith

There was an interesting article by Fundsmith founder Terry Smith in the Financial Times on Saturday under the heading “Think globally and add a dash of small caps”. His articles are usually full of wisdom.

In this case he first tackled the issue that the Capital Asset Pricing Model (CAPM) tells you that your returns relate to how much investment risk you are willing to take on. This might be seen as common sense – why would anyone take more risks if they did not get a better return? But based on an academic study of actual stock market returns, low risk seems to give better returns. This is a persistent anomaly.

But my reservation on this truth is that risk was measured by the volatility of the share price, which is a conventional way to calculate the risk of an individual share. But it simply does not tell you the major risks that a company faces. It only tells you about the level of variability in the share price over the short term, or the amount of speculation there is in the stock. For example, it will not tell you that the company operates in a market that is rapidly changing or the company’s products are subject to technological obsolescence. There are many risks that are simply not reflected in conventional risk metrics which only a study of the market in which the company operators and its business model will reveal the truth about.

Terry also discussed the other conventional wisdom that asset allocation is responsible for most of the returns one obtains – he quoted a figure of 91.5% from another academic study. He said this has led “a large portion of the investment industry to focus almost exclusively on asset allocation”. That’s as opposed to the choice of individual assets.

Mr Smith also criticized the parochial approach of many investors who only invest in their home markets (e.g. UK listed shares for UK investors even though many such companies have very international businesses). He went on to suggest a portfolio of global large-cap stocks plus some small/mid-cap stocks can “achieve the seemingly impossible feat of generating additional return whilst reducing risk”. This is because such a portfolio that might comprise 35% of small cap stocks is more likely to be near the “efficient frontier” for which investment professionals aim.

He concluded by saying that “we should all manage equity portfolios on a global basis and add an element of small-cap exposure”. That might be a puff to some extent for his Fundsmith fund, which I hold – perhaps suggesting Fundsmith could provide one element in this strategy. But it is certainly an approach I have found to be a wise one.

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

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Steps Down With Immediate Effect – Diploma and IDOX

The phrase “stepped down with immediate effect” is used by companies to announce the instant departure of a director. It usually simply means they have been fired. It is of course frequently bad news as it often follows past uninspiring events and it means that the company has to scratch around for a replacement or ask another director to step into the breach.

This week I saw such announcements on a couple of my holdings. The first was Diploma Plc (DPLM) where the CEO Richard Ingram was the victim. The announcement also said “the Board believes that a change in the CEO is in the best interests of the Company and its shareholders”. The surprising aspect here was the Mr Ingram had only joined the company a few months ago and the trading announcement issued on the same day was positive. Mr Ingram had been recruited to replace long-serving CEO Bruce Thompson who retires at the end of September. Clearly the recruitment process seems to have failed but there is always a high chance of failure when recruiting a senior position from outside. John Nicholas, the Chairman, is taking over on an interim basis rather than Mr Thompson. Better to admit a mistake sooner rather than later.

The share price initially dipped on the morning of the announcement, but then rose as much as 4% during the day. Clearly some investors saw it as good news.

This morning there was a similar announcement this morning from IDOX (IDOX). Long-serving CFO Jane Mackie has resigned and leaves the board with immediate effect. That’s perhaps not greatly surprising as she was the CFO in the period when IDOX had to back-track on some rather aggressive revenue recognition practices. A new CEO has recently been appointed so a change in CFO was not surprising. However Ms Mackie is not actually leaving the company until February 2019 which certainly gives the company plenty of time to find a replacement.

The share price of IDOX has fallen by 1.8% today at the time of writing, but I rather judge this as positive news so it might recover I suspect in due course unless there is other news announced. The departure of a finance director sometimes means they have just given some unexpected bad news to the board. I do recall in my early career to suddenly finding my finance director boss was departing for that very reason after a stormy board meeting. He was rather easy going so it was great to be junior to him, but that character defect did not impress the board.

Let us hope that is not the situation at IDOX.

It is unfortunate for investors that such announcements tend to be somewhat cryptic in nature. Often a “settlement agreement” with the departing individual has yet to be proposed or agreed so they don’t want to prejudice the legal negotiations by saying more. But of course they might well inform their major investors while private investors are left guessing.

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

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Whitewash at Gordon Dadds AGM, and Insolvency Warnings

I attended the Annual General Meeting of law firm Gordon Dadds Group (GOR) this morning. The company was tipped as a buy in Investors Chronicle on the 3rd August so I bought a few shares. It’s always good to go to the AGMs of new investments to get an impression of the management and ask a few questions. This is one of only three listed legal firms (the others being Gateley and Keystone which I do not hold).

This AGM was very unusual in that both on the “show of hands” vote and the proxy vote counts, there were no votes against at all, i.e. exactly zero on all resolutions. That is exceedingly unusual for a public company. As I said to the Chairman, he managed to achieve that by not having a share buy-back resolution on the agenda as I normally vote against such resolutions. Likewise no resolution to change to 14 days notice of general meetings. I congratulated him on that and a well run AGM where questions were taken first before the formal business.

There were about a dozen shareholders present, some of whom might have been staff. I questioned the increase in overheads in the last year – they are working to bring that down but it was increased as they “set up to expand” – and the high debtors. Although they bill work in progress monthly, it seems their corporate clients are slow payers. Another shareholder asked how work in progress was valued, and it’s at cost apparently. Otherwise I did not pick up any concerns although the legal market does seem fragmented and it is not clear to me how they are differentiated from others although they do have some specialisations. One might see it as a market ripe for consolidation with too many small firms and Gordon Dadds seem to have acquisition ambitions.

The company only listed on AIM a year ago so it’s early days as yet.

Interesting that the national media failed to pick up on the changes to the insolvency regime announced by the Government last Sunday. Perhaps not surprising on a Bank Holiday weekend although I covered it here: https://roliscon.blog/2018/08/26/insolvency-regime-changes-a-step-forward/

Perhaps private investors were not concerned because they think they can bail-out before such events unlike institutional shareholders who frequently have such large holdings that they can’t place them on the market at any price. But you cannot always do so. I have been caught twice in over twenty years of investing by unexpected administrations of retailing companies who often appear to have lots of revenues and positive cash flows. But a retail market turn-down can catch them unawares when they have high fixed costs (staff and property rentals). The result is often a cash flow problem when quarterly rent payments are due, or an unexpected tax bill appears, or suppliers’ insurers simply get nervous and withdraw cover.

A simple ratio to look at to pick up businesses at risk of insolvency is the Current Ratio which I like to see above 1.4. Remember business only go bust when they run out of cash. However, retailers often pay their suppliers after they have sold the goods to their customers so the Current Ratio is not a reliable measure for retailers. Likewise it tends to be unreliable when looking at software companies where they might have deferred support revenue in their current liabilities which should really be ignored as it will never be paid.

The Current Ratio is easy to calculate (it’s Current Assets divided by Current Liabilities). A better measure but a more complex one is the Altman Z-Score. This was very well covered in this week’s Investors Chronicle where it was argued that it was also a good measure of the overall performance of companies. It’s not foolproof in terms of predicting insolvency but it’s certainly a good warning indicator – the big problem is that accounting figures on which it is calculated are often out of date.

The Z-Score can be obtained from a number of sources as it’s a bit tedious to calculate it yourself – for example Stockopedia display it on their company reports.

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

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Insolvency Regime Changes – A Step Forward

There’s nothing like issuing a major Government announcement on the Sunday of an August bank holiday weekend to get good media coverage is there? But as it’s raining and I have nothing much else to do, I have read the announcement and here is a summary:

The announcement is entitled “Insolvency and Corporate Governance – Government Response” (see https://www.gov.uk/government/consultations/insolvency-and-corporate-governance ). It is the Government’s response to past public consultations on how to tackle some of the perceived problems when companies get into difficulties or go bust. Such examples as House of Fraser (see my past blog posts on that subject where I called for reform of pre-pack administrations), Carillion, BHS, et al.

It aims to tackle issues around company director actions when a company gets into difficulties but one of the main proposals is very significant. That is that the Government intends to introduce a “Moratorium” scheme where a company can hold off its creditors for up to three months while it seeks to develop a restructuring proposal. Although a Moratorium will be a court process and will be supervised by a “Monitor” who is likely to be an insolvency practitioner, the directors of the company will remain in control albeit with some limitations.

Representatives of secure creditors (e.g. bank lenders) did not seem to like this idea at all based on their responses to the consultations, but it’s not quite as generous as first appears. Apart from the “monitoring” requirement to protect the interests of creditors, the initial period of a Moratorium will only be 28 days and can only be extended to 3 months if justified, and the company must be able to meet the normal insolvency rule that current obligations must be capable of being met as they become due during the Moratorium. But it is surely a step in the right direction in that it will provide more chance of those businesses that are not pure basket cases of being rescued to the advantage of trade creditors, pensioners and shareholders. That’s as opposed to the present situation where a pre-pack administration can instantly dump everyone except the secured creditors with massive damage to everyone else.

But directors of companies will need to act more in advance to ensure that a Moratorium is of help. To encourage them to do so the Government hopes to improve shareholder stewardship by identifying means to help the actions of institutional shareholders and others to escalate their concerns about the management of a company by its directors.

In addition the Government wishes to improve board directors effectiveness and training including raising awareness of their legal duties when making key decisions, and developing a code of practice for board evaluations. Comment: it is certainly the case that in smaller public companies the directors often seem to be unaware of their legal obligations and this sometimes extends to larger companies. I have argued in the past that all public company directors should have some minimal education in company law and their other responsibilities when acting as a director.

One issue examined was the payment of dividends by companies when companies were apparently in a weak condition such as having substantial pension liabilities or were paying dividends shortly before they went bust. Whether a company can pay dividends is governed by the calculation of whether it has “distributable reserves”, but that is a calculation that only the company and its auditors might be able to do. It’s not obvious from the published accounts. The Government is to work with interested parties on a possible alternative mechanism.

There were also concerns expressed that some companies are now paying dividends only as “interim dividends” which can escape approval by shareholders at Annual General Meetings. The Government has asked the Investment Association to report on the prevalence of the practice and they will take further steps to ensure that shareholders have an annual say on dividends if the practice is widespread and investor pressure proves insufficient.

In summary, I welcome all of these proposals as a step forward in rectifying some of the defects in the existing insolvency regime. The slight concern is that companies will be reluctant to enter a “Moratorium” due to the adverse publicity it might generate and the costs involved so we will have to see whether that turns out to be the case or not. But almost any restructuring solution is better than a formal administration or liquidation.

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

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Trump Impeachment and No Deal Brexit Planning

Donald Trump has suggested that if he was impeached the stock market would crash and everyone would become poorer. And make no mistake, if the US market crashes then so will other worldwide stock markets including the UK as there is a high correlation between international stock markets.

Is that likely if he was impeached? No it is not. Stock markets can be remarkably immune to political crises. Just look at the negligible impact of the turmoil in the UK as politicians debate Brexit and there is the major threat of a very left-wing Government. What moves stock markets is economic crises, not political ones. Changing the US head of state would have little impact on the US economy.

In any case, the chance of impeachment looks relatively low. Paying hush money to past contacts is not a crime unless campaign funds were misused which currently appears unproven.

In the short term there is perhaps more threat to the UK stock market from a “no deal” Brexit. Having had a quick read of the papers published yesterday by the Government on planning for such, I am not panicking (see https://www.gov.uk/government/collections/how-to-prepare-if-the-uk-leaves-the-eu-with-no-deal#money-and-tax ). The regulatory issues can be accommodated without too much difficulty. What concerns me more is that if customs facilities are not improved well in advance, we might have long queues of vehicles on the motorways here in Kent.

Meanwhile Chancellor Philip Hammond has been stirring the Brexit debate pot with a letter to the Treasury Select Committee which includes this statement: “This January provisional analysis estimated that in a no deal/WTO scenario GDP would be 7.7% lower (range 5.0%-10.3%) relative to a status quo baseline. This represents the potential expected static state around 15 years out from the exit point.”

Anyone who thinks they can forecast the economy so far as 15 years ahead is plain bonkers in my opinion. Economists don’t manage to accurately forecast the UK economy one year ahead let alone 15. Such long-range forecasts are always based on numerous assumptions, most of which are undermined by unforeseen events which have not been taken into account. The Chancellor also forecast that Government borrowing might increase by £80 billion a year because of the reduced GDP by 2033 unless spending or taxation was changed. All this looks like scaremongering to me of the worst kind.

I may favour doing a deal with the EU along the lines of Mrs May’s proposals to assist with trade, but having a no-deal Brexit does not scare me.

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

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Productivity, Sage, Sophos and Investment Trust Discounts

There was an interesting article last week in Investors Chronicle where Bearbull attempted to analyse the variations between company productivity. Productivity, or the lack of it in the UK, is one of the big issues weighing on the minds of politicians of late. Is the productivity of UK companies getting better or worse was one of the questions he attempted to answer.

For investors, productivity is surely one thing we should look at when deciding in which companies to invest. Those businesses that get the most out of the capital they employ (measured by Return on Capital, or ROCE), and also get the most out of their employees, are surely the ones most likely to be successful and generate the profits and dividends we like as investors.

But one needs to combine the two because obviously employees can be traded off against capital. By investing in more automation, employees can be reduced. But there is also the problem that businesses vary in nature. So natural resource companies such as oil producers can have large revenues and profits generated by relatively few staff, while retailers generate equivalent profits from much larger staff numbers.

Bearbull had a stab at producing a combined productivity index for a range of large cap companies, but as the results were still very wide ranging ended up focusing on whether their productivity was increasing or decreasing. Results were still varied.

There is a way to make use of such figures and that is to compare companies in the same business sector. For example software companies employ a lot of staff, but generally little capital apart from their past investment in developed software or in acquisitions. One way I used to look at companies in the software industry when I worked in it was to look at the revenue and profits per employee and I still find those useful measures. They can tell you a lot about the nature of the business.

It’s informative for example to compare two of the larger UK software businesses – Sage (SGE) and Sophos (SOPH). Sage has recently been the subject of a downgrade by analysts at Deutsche Bank and the shares have been heading south for some time as competition from new entrants into the accounting software space seems to be increasing. But at least they are making profits. Sophos is in the hot IT security sector but is still reporting operating losses.

But it’s interesting to look at their sales per employee – that was £124,320 in the case of Sage (13,795 employees) and £116,975 in the case of Sophos (3,187 employees) from the latest Annual Reports that are available. In other words, very similar. Operating profits per employee were £25,154 at Sage while Sophos reported a loss of £8,000 per employee.

The big difference was in average employee costs which were £57,194 at Sage and £95,387 at Sophos. The latter is a very high figure which helps to explain why they are losing money.

Sophos looks to be an example of where the directors and employees are taking most of the profits leaving very little for shareholders – indeed a negative return to them.

Investment Trust Discounts

I mentioned in a previous article the high share price discount to Net Asset

Value at RIT Capital Partners which encouraged me to sell the shares. The discount was actually a premium of 6.8% which I reported although I am advised it had actually been even higher in the recent past.

It is common knowledge with anyone who invests in investment trusts that discounts have narrowed in the last year with popular trusts now often on premiums. The dangers of buying trusts that trade at a high premium was recently evidenced by the fall in the share price of the Independent Investment Trust (IIT). As reported by Citywire recently, the share price unwound by 10.9% in one week after the premium shrank from a peak of 20% in June. It’s now only 6.2% but that’s still too high in my view.

The company performed exceptionally well in 2017 (NAV up 53%) but even so this is surely a case of investors expecting “past performance to be indicative of future performance” when every health warning on stock market investments tells you the contrary. The long-term performance record is good but there is a limit to the price one should pay for anything.

You can track the company’s performance, and the discount it trades at on the Association of Investment Companies (AICs) web site. There are many other relatively high performing investment trusts that still trade at a discount.

Why should investment trusts trade at a discount? Because just looking at the income they produce, if the management and administration charges reduce their income by 1%, when their yield was otherwise 5%, then the share price should be at a discount of 20% because otherwise people can buy the individual holdings of the company directly and increase their income in that proportion. That ignores the relative proportion of dividends paid out of income versus capital growth. Of late we have had lots of capital growth but that is not always the case. If the market starts to go down then share price premiums on investment trusts could well collapse.

A particular problem with investment trusts, and the reason why discounts, or premiums, can sometimes become extreme, is the relatively low volume of share trading even in large trusts, i.e. there is low liquidity. Buyers are often long-term holders with few active traders speculating in the shares. This problem tends to worsen in the summer months when many investors are on holiday so one needs to be wary of trading such shares in that period.

I hold none of the companies mentioned above, for the avoidance of doubt.

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

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