The Signs Were There – Corporate Disasters and How to Avoid Them

This is a review of the recently published book entitled “The Signs Were There” by Tim Steer. It’s worth reading by any investor who invests directly in stock market shares, but particularly by those new to the game. Experienced investors will know about many of the causes of companies collapsing, and how accounts can deceive, from their own past experiences. But it’s best to learn what to look for in other ways.

The book covers many UK examples of corporate disasters – not all of them went bust but many did. It profiles Connaught, NCC Group, Sports Direct, Hewlett-Packard/Autonomy, Cedar Group, iSoft, Utilitywise, Slater & Gordon/Quindell, Mitie, Guardian IT, Tribal Group, Conviviality, Amey, Capita, Carillion, Northern Rock, Cattles, Healthcare Locums, Erinaceous, Findel, AO World and Toshiba; and explains why investors were fooled. I have been involved in a few of those as an investor or trying to help those who were caught out, and have written about some of them in the past to try and educate investors on how to spot the dogs.

The author shows how many of the problems in these companies could have been identified in advance by reading the Annual Reports, or looking at some financial ratios. One comment I saw on the book was that few investors have the time to read Annual Reports – if they don’t they should not be investing in my view. Perhaps one criticism is that the author is an accountant and hence is more used to reading the accounts of companies than the average investor. But that is surely a capability that all investors should acquire. The fact that so many of the above companies had professional fund managers as investors in them, or were acquired by supposedly experienced managers (e.g. Hewlett-Packard/Autonomy) tells you that there is a lack of education on such matters.

Reasons given for disappearing profits are frequently revenue recognition problems, accruals misstated, assets wrongly valued, goodwill unreasonably inflated or not written down, capitalisation of operating costs and unexplainable related party transactions. The author also warns about companies that grow via acquisitions when the acquisitions do not help but enable “exceptional” costs to be buried.

You won’t pick up all the future corporate black holes after reading this book. For example, anyone can be fooled by false accounts where even the cash on the balance sheet simply is not there (e.g. at Globo and Patisserie). Simple frauds can conceal many ills, but most of the examples covered in the book were more down to management incompetence and a desire to present profits rather than losses. As is pointed out, accounting rules permit a lot of interpretation and flexibility which is why published accounts cannot always be relied upon. The book will help you avoid a lot of those errors.

The last chapter covers more general issues about why the “System isn’t working”, i.e. the failings of auditors to identify such problems and what to do about it. The author’s comments on the FRC are similar to those in the recent Kingman review. To quote: “The trouble with the FRC is that, rather like the Keystone Cops, who always arrived late to the scene of a crime, their important investigations often commence some time after the damage has been done”.

One suggestion made is that the FRC could take a proactive role in identifying companies that were at risk. Either by reviewing those shares that were being shorted, or a “specially tailored financial screening tool”. The latter might identify those companies where there was a widening gap between reported profits and cash flows, or other declining financial ratios. That seems an eminently sound idea that should be pursued. A public report of such ratios would be an even better idea.

As the author points out, the amount and quality of published research on companies is declining because of the impact of MIFID rules and market dynamics. So investors need to do more of their own research. This book tells you some of the things to look out for.

I have suggested to ShareSoc that they put this book on their “Recommended Reading List”. Let us hope that it does not get lost like the innumerable cookery books that all cooks who pretend to aspire to be good cooks keep in their libraries but never use. Investors have the same tendency to read numerous books on how to pick stocks but then either forget what they have read or get confused by too many answers. They buy more such books while looking for the one simple answer to their quest for the holy grail of a finding a share on which they can make a fortune. There is of course no one simple answer which is why stock market investment is still an art rather than a science. It is just as important to avoid the real dogs in addition to picking winners if your overall portfolio performance is to be better than average. The book “The Signs Were There” is certainly a book that can contribute to your knowledge of how to avoid the worst investments.

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

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Review of the Year – I’ve Seen Worse

It’s that time of year when I review my overall share portfolio performance. My main objective is to outperform the FTSE All-Share every year using a balanced and diverse portfolio which I did manage to achieve again last year. But I showed an overall loss, including dividends, of minus 5.0%. The FTSE All-Share capital value index was down 12.6% on the year and taking into account dividends that suggests a total return of minus 8.3%.

When I say a balanced portfolio, there are few traditionally defensive stocks in there, and no index tracking funds. The emphasis is on small to mid-cap stocks with hardly any FTSE-100 shares.

The first half year was good, but the last few months of 2018 were particularly bad for many shares that were technology focused or had any pretense of aiming for growth. That’s not to say that there were not a few gainers, but with a large portfolio the numerous losers offset the few shares that rose. You might say that “growth” shares have gone ex-growth as investors put bigger discounts on a gloomier future in general.

Small cap stocks of all kinds were depressed – for example the share prices of two small cap investment trusts (Standard Life UK Smaller Companies and Blackrock Smaller Companies Trust) were down by 18.2% and 7.5%. They both have good long-term track records with well respected managers but an emphasis on UK stocks did not help.

Would it have helped to skew my portfolio to overseas markets? No. That was in fact done by purchasing a number of investment trust holdings but they were some of the worst holdings in the portfolio in the second half.

I did sell down a number of shares in the portfolio as I manage the exposure dynamically to follow overall trends. That means I am now over 20% in cash which is unusual for me as I tend to prefer to be fully invested in shares. But am I looking to rush back into the market? No simply because I am wary that UK share prices will not recover until the Brexit issue is settled and the US market, which we tend to follow, may not recover quickly either. I never act based on economic predictions anyway – I just follow the trends.

It might feel that we have been through a bear market of late but really it’s only been a relatively small correction to date, driven by investor confidence that has been undermined by political events and trade wars.

Looking back a minus 5% return might be considered disappointing but I had minus 17% in 2008, after which there was unbroken series of positive returns with a very good one in 2017. Most of the 2017 high fliers fell back to earth in 2018 though.

One question that investors should always ask themselves is “should I forget stock-picking of individual shares and just buy an index-tracking fund?”. That would save a lot of effort in researching individual companies and monitoring them. The answer is clear in my case. Looking at the last ten years I only underperformed the FTSE All-Share in one year and in some years was way ahead. So I would be a lot poorer if I just relied on an index-tracker.

I am not convinced that stock picking, particularly among small to medium cap shares by someone with a little experience, cannot produce positive returns. In other words, it is not a perfect market in reality. No doubt there are also some investors who have done better than me with more focused portfolios but all I know is that diversity does protect against disasters that are unfortunately all too common in the investment world.

Two things I should probably have paid more attention to were a) running a trailing stop-loss (one that is adjusted to take account of share price rises; and b) being more aggressive in dumping my losers. The latter is something I consistently fail to do but some small cap stocks are very illiquid so getting out of a biggish holding at a reasonable price when the spreads widen can be both difficult and expensive.

Were there any major disasters in my portfolio this year? There are frequently one or two in every year. This year the only big one was Patisserie but only relatively so as it was not one of my bigger holdings. I avoided most of the really big crashes in “hot” shares such as Fevertree by avoiding buying them at their peaks.

Overall a disappointing year so like most stock market investors are probably feeling, “I must try harder”. But don’t we say that to ourselves every year?

As a born optimist, and with buoyant economies in the UK and USA, I am looking forward to the future with some confidence as ever.

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

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IC Share Tips, National Grid, Brexit and the Audit Market

This week’s Investors Chronicle edition (dated 28/12/2018) provides lots of food for thought. One of the most educational is their review of the share tips they published as “tips of the week” in 2018. Unlike some investment publications, who simply forget about their past tips that go nowhere, while lauding their hits, the IC is open about their performance.

They issued 173 “BUY” tips and 24 “SELL” tips in the year. That is quite some achievement by itself as I rarely have more than a very few good new investment ideas in any one year and tend to hold most of my investments from year to year.

How did their tips perform? Overall the “BUYs” returned minus 11.5% which they calculate as being 0.9% better on average than the relevant index. Hardly worth the trouble of investing in them bearing in mind the need to monitor such individual share investments and the transaction costs. The “SELLs” did better at -18.0% versus an index return of -8.8%.

The BUYs were depressed by some real howlers. Such as tipping Conviviality shortly before it went into administration, although they did reverse that tip to a “SELL” before it did so. The result was only a reported 12% loss. As a consequence they are making some “fundamental changes to the way we recommend shares”.

But with so many share tips, the overall performance was not impacted by one or two failures and tended to approximate to the overall market performance. Which tells us that you cannot achieve significant over or under performance in a portfolio by holding hundreds of shares.

I don’t work out my overall portfolio performance for the year until after it ends on the 31st December so I may report on it thereafter. That’s if it’s not too embarrassing. With many small cap technology stocks in my portfolio, I suspect it won’t be good. I always look at my individual gains and losses on shares at the year end, as an educational process. As Chris Dillow said in the IC, “Investing like all our dealings with the real world, should be a learning experience: we must ask what we got wrong, what we got right, and what we can learn. The end of the year is as good a time as any for a round up…”.

One BUY tip they made was National Grid (NG.) in May 2018 on which they lost 11.8%. There is a separate article in this week’s IC edition on that company which makes for interesting reading as a former holder of the stock. I sold most of my holding in 2017 and the remainder in early 2018 – that was probably wise as you can see from the chart below (courtesy of Stockopedia).

National Grid Share Price Chart

National Grid has a partial monopoly on energy distribution and always seemed to be a well-managed business. Many investors purchase the shares for the dividend yield which is currently about 6%. But the IC article pointed out that proposals from OFGEM (their regulator) might limit allowed return on equity to 3%, which surely threatens the dividend in the long term. The share price fell 7% on the day that OFGEM announced their proposals. Bearing in mind the risks of running an electricity network, and the general business risks they face, that proposed return on equity seems to be completely inadequate to me. That’s even if one ignores the threat of nationalisation under a possible Labour Government.

Another IC article in the same edition was entitled “Brexit and the UK Economy”. That was an interesting analysis of the UK economy using various charts and tables. One particularly table worth studying was the balance of trade between the UK and our main trading partners. We have a big negative balance (i.e. import more than we export) to Germany, Spain, Belgium, Holland and Italy but positive balances with Ireland and the Rest of the World – particularly the USA. The article makes clear that our trade with EU countries has been declining – exports down from 55% in 1999 to 44% of all exports. But imports have not fallen as much so the trade gap has been widening. Meanwhile our exports to Latin America and China, which have been good economic growth areas, have remained relatively small.

The conclusions are simple. EU economies such as Germany would be severely hit by any trade disruption on Brexit. But opportunities in rapidly growing markets are currently being missed, perhaps hampered by inability to negotiate our own trade deals with them, and that might improve after Brexit.

Audit Market Review

The Competition and Markets Authority (CMA) have published an “Update Paper” on their review of the audit market. It contains specific recommendations on changes to improve competition and asks for comments. See https://assets.publishing.service.gov.uk/media/5c17cf2ae5274a4664fa777b/Audit_update_paper_S.pdf .

It mentions a long list of audit failings on pages 12 onwards including banks before the financial crisis of 2008, BHS, Carillion, Autonomy (covered in a previous blog post) and Conviviality which was mentioned above.

This paragraph in their executive summary is worth repeating: “Independent audits should ensure that company information can be trusted; they provide a service which is essential to shareholders and also serves the wider public interest. But recent events have brought back to the surface longstanding concerns that audits all too often fall short. And in a market where trust and confidence are crucial, even the perception that information cannot be trusted is a problem.”

One problem they identify is that “companies select and pay their own auditors” which they consider an impediment to high-quality audits. In addition choice is exceedingly limited for large FTSE companies, with the “big four” audit firms dominating that market.

Their proposals to improve matters are 1) More regulatory scrutiny of auditor appointment and management; 2) Breaking down barriers to challenger firms and mandatory joint audits; 3) A split between audit and advisory business within audit firms and 4) Peer reviews of audits.

Their review of FRC enforcement findings suggests that the most frequent findings of misconduct include:

(a) failure to exercise sufficient professional scepticism or to challenge management (most cases);

(b) failure to obtain sufficient appropriate audit evidence (most cases); and

(c) loss of independence (three out of a total of 11 cases).

That surely indicates a major problem with audit quality, and that is backed up by the FRC’s own analysis of audits that they have reviewed with only 73% being rated as “good or requiring limited improvement”.

Auditors are primarily selected via audit committees and there is a noticeable lack of engagement by shareholders in their selection. But that’s surely because large institutional shareholders have little ability to judge the merits of different audit firms.

Would more competition improve audit quality, or simply cause a focus on the lowest price tenders? The report does not provide any specific comment on that issue but clearly they believe more competition might assist. More competition does appear to drive more quality for a given expenditure in most markets however so it is surely sensible to support their recommendations in that regard. The report does emphasise that the selection and oversight of auditors would ensure that competition is focused on quality more than price which is surely the key issue.

A previous proposal was that auditors be appointed by an independent body but that has been dropped, partly due to shareholder opposition. The new proposal is for audit committees to report to a regulator with a representative even sitting as an observer on audit committees where justified. In essence it is proposing much more external scrutiny of audit committee activities in FTSE-350 companies and decisions taken by them.

The end result, at some cost no doubt, would be that both auditors and audit committees will be continually looking over their shoulders at what their regulators might think about their work. That might certainly improve audit quality so for that reason I suggest this proposal should be supported.

The requirement for “joint” audits where two audit firms including one smaller firm had to be engaged seemed to be opposed by many audit committee chairmen and by the big four accounting firms. Some of their objections seem well founded, but the riposte in the report is that evidence from France, where joint audits are compulsory, suggests they have a positive impact on audit quality. Moreover, it would clearly increase competition in the audit market.

In summary, the report does appear to provide some sound recommendations that might improve audit quality. But investors do need to respond to the consultation questions in the report as it would seem likely that the big audit firms will oppose many of them.

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

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Surprise Offer for Earthport

Shareholders in payments company Earthport (EPO) must have thought they had woken up this morning in a dream. There is an agreed cash offer for the company from Visa at 30p when it was trading at 7p before Christmas.

I did hold Earthport in the past, but although revenue rose over the years profits consistently remained negative. Management changes and continual fund raising did not impress either. My last sale was at 32p in January 2016 for an overall small loss so I am glad I did not hold on.

Did they have some useful technology that Visa can employ? Perhaps so but this was clearly an offer management could not refuse.

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

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Bad Blood and a Hymn for Christmas

One of my books for Christmas reading is “Bad Blood” by John Carreyrou. This is the story of Theranos who developed a novel way of testing blood samples. It has won the FT Business Book of the Year award, perhaps because it was written by a Wall Street Journal reporter and is a good example of investigative financial reporting.

Theranos was set up by the very young and physically attractive Elizabeth Holmes who apparently proceeded to attract many elderly males to her cause. She even had Henry Kissinger and George Shultz (former US Secretary of State) on her board. Her pitch to investors was that she had developed a blood testing method that would remove the need for drawing blood from a vein via a trained phlebotomist. Just a pin-prick on a finger would suffice and anyone could do it so home testing by patients could be done – exceedingly useful for those with on-going medical conditions. It could also avoid the “needle-phobia” that some people suffer from – I know at least one person who would regularly faint when a needle was presented.

There are about 300 million blood tests taken each year in the UK now at very significant cost to the NHS as they cost several pounds each. So you can see how attractive a business would be that could reduce the cost of blood tests worldwide.

Elizabeth Holmes was also a very good sales person in promoting the gospel of reducing and simplifying the process of blood testing. She raised many millions of dollars from investors such as Larry Ellison, Rupert Murdoch and west coast venture capital firms. Later rounds valued the company at $9 billion!

But the only problem was that the product produced unreliable results, i.e. the reports produced were not accurate. This could be potentially life threatening as patients could think they were perfectly healthy when they were not or patients could be referred for emergency investigations when they were perfectly normal. Not only that but the company was faking some demonstrations of the product and actually using a full-size blood-testing machine from Siemens to produce results from such small blood samples by simply diluting the samples to increase the volume – not a sound practice.

Business wise, the book is an interesting insight into the milieu of the venture capital world in the USA and how investigative reporting can get around problems of what was a very secretive company where all employees signed confidentiality agreements. But it is also an example of how vibrant is the US venture capital world when hundreds of millions of dollars can be sunk into a business with a great concept but ultimately unproven product.

In summary, the book is an amusing read in parts about the gullibility of investors and the peculiarities of doing business on the west coast of the USA, but I would not rate it as one of my favourite business books. That’s probably because I prefer happy endings. Elizabeth Holmes was charged with criminal fraud in 2018.

A Hymn for Christmas 2018 (after Christina Rossetti)

In the bleak midwinter, frosty wind made moan,

but earth stood soft and wet due to global warming,

markets had fallen, down and down,

in the bleak midwinter, only yesterday.

Our god mammon cannot hold, nor Governments sustain,

stock prices will flee away despite his reign,

in the bleak midwinter no stable place can be found

when market confidence freezes.

 

What can I give, poor as I am?

if I were a shepherd, I would bring a lamb;

if I were a wise man, I would do better;

yet what can I give, but my hopes for a better year.

 

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

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Market Trends, Interest Rates, and Yu Group Accounts

Yesterday was another dismal day in the markets. The US fell significantly allegedly caused by the rise in interest rates announced by the Federal Reserve and the UK market followed it down this morning. The US rate rise was widely expected although perhaps slightly lower estimates for US economic growth had an impact. But when the markets are in a bear mood, excuses for selling abound. Meanwhile the Bank of England has announced today that their base rate will remain at 0.75%. The UK market recovered somewhat after it’s early fall, even before that announcement at 12.00 am. Did it leak one wonders, or is it those city high fliers with big bonuses stimulating the market before it closes for Xmas? Or was it the news from GlaxoSmithKline (GSK) that a de-merger was to take place? Many market trends are unexplainable so I won’t say any more on that subject.

The general state of markets was highlighted in a recent press release from the Association of Investment Companies (AIC). They represent investment trusts and reported that the industry’s assets hit an all-time high of £189 billion in September but pulled back subsequently. At the end of November the average investment company returned 1.3% over the prior year they said, but that suggests that when the year ends most will be lucky to show any return at all. Investors who manage to beat zero for 2018 should consider themselves either lucky or wise.

But the good news the AIC reported was that many investment trusts, 37 of them, have reduced fees in 2018. Even better news was that 9 of them abolished performance fees which I believe is a good move for investors. There is no evidence that performance fees improve investment managers’ performance and they just lead to higher fees. Needless to point out that the lack of returns in 2018 might have encouraged the trend to cut performance fees!

Not only that but the average return of 1.3% by investment companies beat that of the average of open funds who showed a loss of 2.6% and the FTSE All-Share with a loss of 6%. Perhaps this is because there are more specialist or stock-picking investment trusts as opposed to the many open-ended index trackers and heavy weighting in a few large cap dominated sectors in the FTSE. That shows the merits of investment trusts (I hold a number but very few open-ended funds).

Coming up to Xmas and the New Year, it’s worth warning investors about share trading in small cap stocks and investment trusts though. Both often have low liquidity and this is exacerbated over the holiday season as active investors take a break. The result is that such stocks can spike or decline on just a few trades. Might be a good time to take a holiday from following the markets even for us enthusiastic trend followers.

Yu Group (YU.) is the latest AIM company to report fictitious financial accounts. Yu Group is a utility supplier to businesses and only listed on AIM in March 2016, reached a share price peak of 1345p in March 2018 and is now 68p at the time of writing, i.e down 95% – ouch!

An announcement by the company yesterday, following a “forensic investigation” of its past accounts, reported more bad news including serious deficiencies in the finance function. They are now forecasting an adjusted loss before tax of between £7.35 million and £7.85 million for the year ending December 2018, but that excludes lots of exceptional costs including possible restatement of prior year accounts. Future cash flow is also called into question. In summary it’s yet another dire tale of incompetent if not downright fraudulent management in AIM companies which it seems likely the auditors did not spot. The FCA and FRC should be investigating events at this company with urgency. The AIM Regulatory and NOMAD system has also again failed to stop a listing or what clearly has turned out to be a real dog of a business.

Let us hope that the mooted changes to financial regulation in the UK bear some fruit to stop these kinds of disasters in future years. Risks of business strategy failures and general management incompetence we accept as investors. Likewise general economic trends, even Brexit risks, and investor emotions driving markets to extremes we accept as risks. But we should not need to accept basic accounting failures.

On that note, let me wish all my readers a Happy Christmas and a prosperous New Year.

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

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All Change in the Audit World

Readers don’t need to be told that the audit profession has come in for a lot of public criticism of late. Too many unexpected failures of companies and phantom profits being reported are the cause, apart from simple inability to detect fraud. There are three important announcements today that aim to tackle these issues.

The first is the Kingman Review of the Financial Reporting Council (FRC) published by the BEIS. Sir John Kingman basically says that the FRC is not fit for purpose – it should be scrapped and replaced by a new body called the Audit, Reporting and Governance Authority (ARGA). Not exactly a catchy title but the objective is certainly clear.

He wants the new body to have wider powers and a clearer remit. He also criticises the “consensual” approach the FRC takes to regulatory work, that it has an inappropriate culture and staff recruitment is often informal. In summary it’s a pretty damning report on the effectiveness of the FRC and how it currently operates.

BEIS have also announced a review of audit standards by Donald Brydon which will look at the quality and effectiveness of the audit market.

Plus the Competition and Markets Authority (CMA) have proposed new legislation that would separate auditor work from consultancy activities (the latter is 75% of their revenue at present) – what they call a “structural break-up”. They also suggest that audits of the biggest firms (i.e. FTSE-350) be done by 2 firms of which one must be outside the big four audit firms. This might reduce their stranglehold on the market. The CMA also proposes “more regulatory scrutiny” of audit firms to ensure that not just the cheapest audit firm is selected. Does this mean there will be a lot more bureaucracy involved? Perhaps so.

No doubt all these proposals will be subject to public consultation so they may get watered down. But surely these are moves in the right direction.

See https://www.gov.uk/government/news/independent-review-of-the-financial-reporting-council-frc-launches-report and https://www.gov.uk/government/news/cma-proposes-reforms-to-improve-competition-in-audit-sector for more information.

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

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