Another Fine for Grant Thornton over Audits at Sports Direct

Back to more serious issues after my last blog post on selecting a Prime Minister. The FRC have issued penalties against Grant Thornton for their audit work at Sports Direct in 2015-16 and 2017-18. One concern was about the failure to recognise that contracts with a delivery company were probably “related party” transactions.

To quote from the FRC announcement: “The audit failings in this case were serious and relate to fundamental auditing standards. It is particularly important that auditors follow up with due rigour where they have identified potential related party transactions as a significant audit risk. Auditors must adopt a mindset of professional scepticism, and exercise good judgment based on sufficient and properly documented evidence. The package of financial and non-financial sanctions imposed by the FRC on the auditors in this case will help to drive improvements at the firm and the wider industry.”

See https://www.frc.org.uk/news/july-2022/sanctions-against-grant-thornton-uk-llp-and-philip  for more information.

This is of course not the first time Grant Thornton has been involved in defective audits – see the cases of Patisserie Valerie and Globo for example.

Grant Thornton may be more careful in future but as I keep on saying, even audited accounts cannot be trusted at present. I don’t think that will change until the penalties for failed audits are made larger and the penalties for errant directors who publish misleading accounts made a lot more severe.

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

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How to Choose the Next Prime Minister

I have watched the debates of the candidates for the next leader of the Conservative Party, and hence for the position of Prime Minister. I am not a Conservative Party member so will not get a vote but for such an important job it is worth stating how I might decide who I would prefer.

I do not think it is worth deciding on the basis of their stated policies. They all believe in tax cuts, but some sooner than later. None of them talked about how they would cut Government expenditure to maintain a balanced budget and allow room for tax cuts. They all believe in the net zero carbon emissions policy although within what is affordable and achievable.

But policies advocated by politicians tend to change after they get elected and get faced with the realities of advice from civil servants, the Bank of England and opinion polls.

There is a simple way to decide who to support. Who would you wish to work for if offered a job as a cabinet member in their administration? Who is a leader you could follow and have some trust in? Who appears confident and decisive, requirements for any natural leader? Who has the charisma to win over colleagues in your party to your adopted policies and in due course the general public so you can win the next general election?

On that basis I think there are only two candidates who pass those hurdles – Rishi Sunak and Tom Tugendhat. But Penny Mordaunt and Liz Truss seem less confident while Kemi Badenoch is an unknown quantity to many voters. Unfortunately ladies who wish to get elected need to be forceful and exude confidence like Margaret Thatcher always did but the three now standing do not. They are not obviously born leaders who could unite a divided Conservative Party which always has a tendency to fragment.

Boris Johnson had the required profile which is why he was successful at winning elections, but fell down on other personal qualities and clearly won’t be invited to join the next administration as he is now a political liability.

As between Rishi and Tom, the former has more ministerial experience and should have a stronger financial background so I would tend to go for the former. Wealthy people tend to be a political liability in the UK where the politics of envy is so pervasive but I think Rishi has the personal charisma to overcome such prejudices and he certainly delivers good speeches.

How Conservative Party Members and MPs view these issues will soon be revealed but I hope they follow the same chain of thought.

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

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Restoring Trust in Audit – A Long Way to Go Yet

The Financial Reporting Council (FRC) have recently published a “Position Paper” entitled Restoring Trust in Audit and Corporate Governance. It sets out how the FRC will be supporting the Government’s reforms under the new ARGA regime.

This is not a very exciting document as it’s very short on specifics. For example under Corporate Governance and Stewardship is says “including a provision for boards to consider how audit tendering undertaken by the company takes account of the need to expand market diversity…”. What exactly does that mean?

However it does say that the Government intends to put Actuarial Regulation on a statutory footing which is long overdue and the intention is to put ARGA on a new funding basis with market participants paying a levy to meet its regulatory function costs. So perhaps auditors should read this Position Paper carefully.

The Position Paper can be obtained from here: https://www.frc.org.uk/news/july-2022/frc-sets-out-next-steps-in-transition-to-new-regul

There might have been more information provided in a webinar on the 14th August but I missed it for two reasons: 1) they sent the login information but it ended up in a spam folder on my BT server; and 2) They sent it as a Teams invite but even though I chose the web browser option it blocked me with an incomprehensible error message. Is it just me that has endless problems with Teams? I wish people would use other products such as Zoom for webinars which I never have problems with.

Incidentally the latest example of the failures of the audit profession was an announcement by the FRC of sanctions against UHY Hacker Young LLP and their audit partner in relation to Laura Ashley Holdings.

To quote: “LAH’s shares were listed on the main market of the London Stock Exchange. As at 30 June 2019, the Group had 155 UK stores, employing over 2,700 people. The Group’s revenue, operating profit, profit before tax and profit after tax consistently declined between FY2016 and FY2019, and the Group’s loss after tax increased ten-fold from £1.4m in FY2018 to £14m in FY2019. Against this backdrop, the audit reports for FY2018 and FY2019 were unmodified and noted no material uncertainty related to the use of the going concern assumption”. Laura Ashley went into administration in April 2020.

The fine imposed by the FRC was only £217,500, a trivial amount!

See https://www.frc.org.uk/news/july-2022/sanctions-against-uhy-hacker-young-llp-and-martin for details.

There is certainly a long way to go to restore trust in the audit profession after a whole series of failures in the last few years.

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

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Grant Shapps for Prime Minister?

Transport Minister Grant Shapps has announced his candidacy for the position of Prime Minister and with two others yesterday the field is getting quite crowded.

But Shapps has a very poor record as Transport Minister. Among his negative contributions has been the promotion of Low Traffic Neighbourhoods (LTNs) to tackle the Covid epidemic – a totally misconceived policy and implemented without local consultations; support for HS2 – an enormous white elephant; a rewrite of the Highway Code which makes some people more equal than others on the road; a £2 billion investment in cycling and walking to promote “active travel” and “behaviour change” and he keeps bailing out Transport for London (TfL) allowing Sadiq Khan to continue to run an uneconomic service instead of reforming it. His response to the national rail strikes has also been to line up for a fight with the unions while committing £1 billion to “modernisation” of the railways; basically throwing more money at an uneconomic and outdated transport technology.

Meanwhile the road transport network gets ever more congested and drivers pay ever more in taxes and road charges such as in CAZ and ULEZ schemes.

I certainly would not support Shapps for Prime Minister. But what of the other candidates? A number wish to cut taxes. A laudable policy but to be able to do that without increasing public borrowing means a reduction in public expenditure. None seem to be promising that (for example Shapps wants to spend considerably more on defence).

We would all like a cut in the price of diesel/petrol which might help to stimulate the economy as high prices impact the delivery of goods and services. But most of the increase of late has come from the market price of oil not from taxes (Fuel Duty rates have actually been reduced recently).

Rishi Sunak seems to be one of the few candidates who is wisely not promising hand-outs to the electorate if he gets the job.

But no doubt we will learn more about the other candidates over the next few weeks. As in previous Conservative Party elections, it may be a case of who avoids the most gaffs and who is least disliked by MPs that wins the day. Boris Johnson only got the job because he seemed likely to break the deadlock over Brexit but there should surely be no rush to appoint a replacement.

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

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Big Miners and How Far Ahead Do You Look?

The last couple of days have seen a jump in the share prices of big miners such as Rio Tinto (RIO) and BHP (BHP). They have risen as much as 5% over the last two days, after falling substantially from their peaks at the start of June. The price of BHP shares has been affected however by the free distribution of shares in Woodside Energy (WDS) on the 1st June to BHP shareholders.

I had a quick look at the current forecasts for RIO and BHP and Stockopedia gives a forward p/e of 5.1 and 6.3 respectively and dividend yields of 14.0% and 13.3%. These are not dividends that are obviously at risk because earnings cover their dividends so surely the shares appear to be selling at bargain prices? But the reason the shares are apparently cheap is no doubt because they are heavily dependent on the price of iron ore and the demand for steel and copper.  In both case EPS are forecast to fall in 2023. The long-term outlook for copper demand is high as the world electrifies but there is short-term concern about iron ore demand and the price has been falling sharply of late. This is because construction activity in China has been falling and the Chinese Government has taken steps to reduce production of steel.

But as in any commodity market, prices are influenced by two things – demand and production and while demand can vary quickly production cannot because developing new mines takes years. Production can only respond to demand relatively slowly – that’s why prices of the commodities have been racing ahead.

Investors have the problem of forecasting not just one or two years ahead (because the shares look good value on those horizons) but even further in the future and that is the difficulty. Will the big miners still enjoy a favourable market and political environment with high commodity prices a few years hence? That is the question that investors need to ask themselves.

But the answer is unknowable which is probably why the sector looks cheap. For example, who could have forecast the recent turmoil in the UK political scene and the abrupt departure of a Prime Minister who had won a large electoral mandate just a couple of years ago?

The cover of the BHP Annual Report states (see image above) states “The Future is Clear” but that is far from the truth.

The companies mentioned are affected by political events in China which are even more unpredictable. In summary, the companies look cheap because there is great uncertainty about their future. Big miners have looked cheap in the past but then have been hit by economic recessions and investment in new production which came on stream as demand fell. It’s in essence a tricky sector in which to invest. Will big miners continue to show restraint over new capital investment or acquisitions which they have not always done in the past? Will the management forget the history of the sector and expand production based on rising commodity prices?

I already hold the companies mentioned but I am not rushing into buying more of their shares while the worldwide economic outlook looks poor. But investors who desire the dividend income may find them attractive at present.

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

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Energy Security Bill and the Next Prime Minister

Yesterday the Government introduced the Energy Security Bill into Parliament. It is good to see that the Government continues to function after the recent political upheavals, but would it not be good to get back to some normality as opposed to the recent dramas?

The new Bill aims to:

  • Boost Britain’s energy independence and security.
  • Attract private investment, reindustrialise our economy and create jobs through new clean technologies, as well as protect consumers.
  • Introduce new powers to help prevent disruption to fuel supply because of industrial action, malicious protests and on grounds of national security (comment: surely to be welcomed).

See https://www.gov.uk/government/news/plans-to-bolster-uk-energy-security-set-to-become-law for details.

It includes new powers which will enable the extension of the energy price cap beyond 2023, shielding millions of customers across the country from being charged “unfair” prices as they call it. Or to put it another way – to protect consumers from the real world of market prices and hence making it uneconomic for some companies to operate in this sector. This is surely not a very “conservative” approach!  There are better ways to subsidise household fuel bills.

The clear objective is to reduce reliance on imported oil and gas and encourage offshore wind farms, nuclear power generation and other infrastructure that we need to achieve carbon reductions although the growth of nuclear is still at a snail’s pace. It is certainly worth reading the document on the Bill’s contents and the associated British Energy Security Strategy mentioned in it.

Let us hope that any new Prime Minister does not get the job by promising more tax cuts. It’s clear that Government expenditure is rising by commitments in the Energy Security Bill for example and in many other areas when what is really needed is reducing the amount of our wealth that is spent by the Government. In the last couple of years we have had a quasi-socialist economy with more willingness to interfere in the economy by the Government. But civil servants consistently back the wrong horses.

What the country really needs is a period of stability under a competent leader who everyone can support. That is the way forward for a good business environment which will instil confidence in investors, particularly ones overseas.

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

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Comments on GB Group and Voting Suggestions

GB Group (GBG) is a provider of digital location, identity verification and fraud prevention systems. Because of the need to identify people quickly and at low cost in the digital world, it has been a great success in the last few years and has become one of the largest AIM companies. Revenue has grown from £87m to £242m in the last 5 years although profits have been less consistent. The share price peaked at about 950p last September but is now down to 390p at the time of writing, i.e. a 59% fall.

Having purchased the shares in 2011-13 I am still showing a profit but it’s rapidly disappearing although I did sell some at higher levels. This is a typical example of a small cap technology stock at present. Nobody is buying while there are some sellers even though the prospective normalised p/e is only 18 which for a profitable growth stock seems very low.

Here’s a comment from Techinvest newsletter last week on GB Group: “Good cash generation and a strong balance sheet were factors that enabled GB Group to significantly strengthen its position in the key US market through the acquisition of Acuant last November”. They tipped it as a “buy”. Perhaps there is some risk associated with the deal and there were a large number of shares issued as part of the transaction, possibly to weak holders. Readers will need to judge for themselves whether this is now cheap enough to consider buying but I think it’s worth making some comments on the voting for the Annual General Meeting on the 28th July.

This will be a hybrid Meeting using the LUMI platform for those who don’t wish to travel to Chester. That usually works well.

But not all directors are up for re-election which is best practice for all companies although not legally required. I wished to vote against the reappointment of the Remuneration Committee Chair but cannot do so. The Chairman lost my vote instead although he is being replaced in September anyway.

My main concern is the replacement of the bonus arrangements for executive directors with a new Performance Share Plan (PSP) that replaces an Annual Bonus and Share Matching Plan. The new PSP is claimed to be more aligned with majority market practice. But in essence it will permit the award of nil-cost options with performance conditions. What are the performance conditions? They do not say. But there will be a fourth KPI added to maintain a focus on ESG improvements and communication.

Without going into details this looks like another complex remuneration scheme likely to increase total director pay (the CEO earned £1.3 million last year which I consider quite enough for a middling size business (profit last year was only £15 million so the directors total pay of £3.4 million was a significant chunk of the profits).

When remuneration schemes are changed it’s usually because the directors do not think they are paid enough or the existing scheme does not produce the desired results.

I am therefore voting against resolutions 7, 8 and 9 on the agenda as well as 3, 10 and 15 (share buy-backs for this company would be very unlikely to be appropriate). I am voting against Ernst & Young as auditors after the laughable $100mn US settlement over ethics exam cheating. See FT report here: https://www.ft.com/content/2fd2a584-3e20-466b-98d7-d26a750aeb90 . It seems auditors cannot even be trusted not to cheat in exams.

I suggest other shareholders vote the same way.

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

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Techinvest Comments on Technology Stocks

The latest edition of the Techinvest newsletter has just been issued. This is a newsletter that comments on smaller cap UK technology stocks and is always worth reading for those who hold such shares as I do. The latest editorial is particularly worth reading in my opinion. I quote from some of it below.

“Between 1994 and 2000. the gain on the Nasdaq index was circa 590%. It subsequently lost around 76% of its peak value in the tech stock crash that played out over the next three years.

As we have commented before, however, we doubt that the bear market this time will follow the path taken during the unwinding of the dot.com bubble. For one thing, current tech stock valuations are not as stretched as they were back then. Also, tech is a much more established part of the economy today, benefiting from developments such as digitisation, automation, and cloud services upon which modern enterprises are increasingly reliant. The dot.com crash was driven primarily by realisation among investors that a speculative bubble had formed in tech stock prices. By comparison, tech stocks are selling off today in response to concerns about events in the real world, chiefly supply chain shortages and rising inflation. Fears of a looming recession in particular has dented risk appetite and made investors cautious about backing growth stocks at a time when the outlook for the economy is turning down. Investors are also showing preference for safe haven blue-chip stocks at the expense of the smaller cap sector. Unfortunately, most tech companies with a London-listing are small cap and have suffered accordingly due to their perceived lack of defensive qualities relative to larger cap brethren in old economy sectors.

Given that most tech operators continue to report strong results and appear to be absorbing the impact of supply shortages and rising operating costs reasonably well, the current sell-off may seem irrational. But markets look ahead and try to discount events that appear likely to occur in the medium term. A worsening economic situation later this year and into 2023 does seem likely and therefore needs to be discounted in current stock prices. Whether this justifies the heavy falls seen in tech stock prices, however, is questionable. After all, tech would seem to have the wherewithal to come through a downturn in better shape than many other parts of the economy. Balance sheets are generally strong in the tech sector and many operators have good cash generation and high levels of reliable recurring revenue. Secular growth trends, such as automation and digitisation, also provide a strong underpinning for tech demand even if IT budgets become more constrained in a downturn. While we recognise some justification on economic grounds for the sharp de-rating of tech stocks since last year, we also feel there is an element of overreaction driven by fear and short- termism. Good stocks have been pulled down alongside ones that have weaker fundamentals, creating some attractive buying opportunities”.

Comment: As the editor points out private equity investors are pouncing on good opportunities in the UK – EMIS and Ideagen are examples of recent bids at very substantial premiums. If a recession does come, those technology businesses with high recurring revenue and good balance sheets may not suffer much. Once a customer has become reliant on technology they will rarely ditch it or change suppliers. So they can be very defensive stocks to own. The ones to avoid are those with no profits, poor cash flow and reliance on future fund raisings which may not be forthcoming in a recession.

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

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What is the Purpose of a Public Company?

My previous blog post talked about the mania for kowtowing to ESG issues that seem to be creeping into public companies. What exactly is the purpose of a company? Is it to generate financial returns for shareholders or does it have wider responsibilities?

Section 172 of the Companies Act spells it out. Its primary duty is “to promote the success of the company” but the Act does recognise other responsibilities by saying also that:

A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to—

(a) the likely consequences of any decision in the long term,

(b) the interests of the company’s employees,

(c) the need to foster the company’s business relationships with suppliers, customers and others,

(d) the impact of the company’s operations on the community and the environment,

(e) the desirability of the company maintaining a reputation for high standards of business conduct, and

(f) the need to act fairly as between members of the company.

This clearly gives company directors wide discretion to support environmental or other ESG issues that may be influenced by the company’s operations. And it makes clear that employees and the wider community are stakeholders in a company.

There was no great opposition to this wording when the last Companies Act was passed in 2006 and I personally believe it is quite reasonable. But the balance between the financial interests of shareholders (members) and the wish by companies and their boards to dabble in politics has swung too far away from sound ethical principles. For example, some companies are intervening in the contentious issue of abortion in the USA. Is that in the interest of their employees? That’s basically a political or religious question that cannot easily be answered.

Clearly companies have to obey the law so if the Government mandates specific legislation on environmental or social issues then companies have to comply. But do they need to, or should they, promote policies that attempt to influence behaviour in the wider community?

For example, should Ben & Jerrys have stopped selling ice cream in Israel because they disagreed with the policies of the Israeli Government?

Companies always have conflicts of interests in their operations which they have to reconcile with the prime objective of promoting the success of the business. For example paying their employees more might be in the interest of the employees but might undermine the financial position of the company. The directors need to balance their responsibilities to the different stakeholders.

What they should not be doing is trying to win a popularity contest in the social media.

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

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Is ESG Mania Out of Hand?

This week the mania for Environmental, Social and Governance (ESG) issues in companies appeared to get totally out of hand. ESG is a ragbag of policies that companies like to support to show how socially aware they are and are in keeping with the times and the mood of the public. Here are a couple of examples of this mania:

A report by Cliff Weight on the Tesco AGM noted this response to a question: “Are you plainly making a token gesture to climate change? Answer. We have >350 people working on these issues. We are very conscious of our responsibilities”. What exactly can these 350 people be working on? It seems a ridiculously high figure even allowing for the fact that Tesco has about 2,700 stores in the UK. The cost of 350 people must be high and these people are simply an unproductive overhead which all good businesses try to minimise. They are not adding to sales or making the business more efficient.

I also read the Annual Report of Speedy Hire – all 212 pages of it printed on heavy paper to add to our postman’s load. For a company that is in the business of hiring out tools and equipment they found it necessary to spend 2 pages on ESG issues and how they are reducing carbon emissions by converting to electric or hybrid vehicles. Their new “innovation centre” depot in Milton Keynes is powered by 670 solar panels and is also “home to a wellbeing and wildflower garden, an 18-metre living wall and beehives made from repurposed hard hats”.

The Report also says: “Speedy has long been committed to sustainable growth and recognises the increasing stakeholder focus on climate change and the related environmental, social and governance considerations within its business. A new Sustainability Committee of the Board has been established to assist the Board in its oversight of the Company’s ESG strategy and support the Board on all sustainability matters. This will include supporting the Board’s ongoing evaluation of environmental risks and our reporting under the Taskforce for Climate Related Financial Disclosures”. So that’s more unproductive effort to divert the attention of management.

These are typical examples of what every Annual Report of public companies now contain with companies keen to demonstrate that they are in the vanguard of a social revolution. But does it really help to improve the returns to shareholders?

A report in the FT suggests there is some reaction against this mania with an article headlined “Shareholders back away from green petitions in US proxy voting season”. The article suggests shareholder resolutions on ESG issues are being defeated, particularly those that impose prescriptions on management although there is more support for improved reporting.

Perhaps if we are heading into a recession as some people believe, we may see a reduction in this needless expenditure of money and management time on unproductive issues.

Note that I hold no shares in Tesco or Speed Hire at the present time.

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

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