Economic Trends, Audit Quality and the Importance of Management

The news on the epidemic and its impact on financial news continues to be consistently bad. GDP rebounded in May to be up 1.8% but that’s a lot less than forecast. It fell 20.3% in April but as many businesses did not reopen until June perhaps the May figures are not that surprising.

Masks now have to be worn in shops. This will be enforced by the police with possible fines of £100. That will surely discourage some people from shopping on the High Streets.

The BBC ran a story today that said that scientists forecast a second wave of the virus in Winter with up to 120,000 deaths. But that is a “worse case” scenario. The claim is that the colder weather enables the virus to survive longer and with more people spending time indoors, it may spread more. I think this is being pessimistic but it’s certainly not having a positive effect on the stock market.

The London Evening Standard ran a lengthy and very negative article yesterday on the impact of the virus on London with a headline describing it as “an economic meltdown”. It suggested 50,000 jobs will go in the West End alone due to a decline in retail, tourism and hospitality sectors. Commuters are still reluctant to get on public transport – trains, underground or buses. In Canary Wharf only 7,000 of the 120,000 people who normally work there are at their desks it is reported. One problem apparently is that with numbers able to enter lifts being restricted it can take a very long time to get all the normal staff at work in high rise buildings. Hotels, clubs and casinos have been particularly hard hit with the extension of the Congestion Charge (a.k.a. tax) discouraging visits. 

Audit Quality

The Financial Reporting Council (FRC) has confirmed what we probably already knew from the number of problems with company accounts – that audit quality has declined in the last year. Following reviews of audits by the major audit firms including PwC, Deloitte, EY, KPMG, BDO and Grant Thornton there were a number of criticisms made by the FRC. The firms PwC, KPMG and Grant Thornton were particularly singled out. The last firm was judged to require improvement in 45% of its audits.

We were promised a tougher stance from the FRC but it is clearly not having the required impact. Published accounts are still clearly not to be relied upon which is a great shame and undermines confidence in public companies.

There were a couple of interesting articles in last week’s Investors Chronicle (IC). One was on the investment approach of Harry Nimmo of Aberdeen Standard. He is quoted as saying: “We do measure prospective and future valuations – it’s not completely ignored. But it doesn’t lead our stock selection, and we don’t have price or valuation targets”. Perhaps he does not trust the accounts either? He does apparently screen for 13 factors though including some related to momentum and growth.

Management Competence

The other good article in IC was by Phil Oakley headlined “How important is management”. If you don’t trust the accounts of a company, it’s all the other factors that help you to judge the quality of a business and the prospects for long-term returns which are important. Phil says that “management does matter” but he thinks some investors overemphasise it’s importance.

How do you judge the quality of the management? One can of course look at the results in the financial numbers over past years but that can suffer from a major time lag. In addition management can change so past results may not be the result of work by the current CEO but their predecessor. This is what I said in one of my books: “Incompetent or inexperienced management can screw up a good business in no time at all, although the bigger the company, the less likely it is that one person will have an immediate impact. But Fred Goodwin allegedly managed to turn the Royal Bank of Scotland (RBS), at one time the largest bank in the world, into a basket case that required a major Government bail-out in just a few years”.

RBS was also a case where the company’s financial results were improved by increasing the risk profile of the business – the return on capital was improved but the capital base was eroded. Management can sometimes improve short term results to the disadvantage of the long-term health of the business.

Is it worth talking to management, say at AGMs or other opportunities? Some people think not because you can easily be misled by glib speakers. But I suggest it is so long as you ask the right questions and don’t let them talk solely about what they want to discuss. Even if you let them ramble, you can sometimes pick up useful tips on their approach to running the business. Are they concerned about their return on capital, or even know what it is, can be a good question for example. I recall one conversation with an AIM company CEO where he bragged about misleading the auditors of a previous company about the level of stock they held, or another case where a CEO disclosed he was suffering from a brain tumour which had not been disclosed to shareholders. Unfortunately in the current epidemic we only get Zoom conversations rather than private, off-the-record chats.

Talking to competitors of a business can tell you a lot, as is talking to former employees who frequently attend AGMs. Everything you learn can help to build up a picture of the personality and competence of the management, and the culture that they are building in the company. The articles being published on Wirecard and Boohoo in the last few days tell us a great deal about the problems in those companies but you could have figured them out earlier by some due diligence activity on the management.

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

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Boohoo – Should I Speculate in the Shares?

There has been a lot of media comment on fast fashion retailer Boohoo (BOO) after publicity on the working conditions in the clothing industry in Leicester where at least some of its products are produced. The suggestions are that people are paid less than the legal minimum wage and work long hours in poor conditions, even possibly breaching Covid-19 regulations. The company has launched an immediate review led by a QC into these allegations, although the company has other sources of supply overseas and it seems that those produced in Leicester may simply be repackaged there.

The company also came under attack from shorter Shadowfall who published a damaging dossier in May which you can find on the web. The share price has been as high as 400p this year, but fell to close at 224p last night. However it’s making a sharp recovery today.

I don’t currently hold the shares but I did hold them from 2014 to 2017/18 and made considerable profits as a result. Last night the share price was back to near where I sold. Should I buy back into the shares is a question I face and my answer is probably not. These are my reasons:

The company has obviously been on a roll in the last few years with revenue doubling in the last 3 years. They have exploited the growth in the use of the internet for clothes shopping in the same way as ASOS, thus leaving traditional retail stores in their wake. With low price clothes that appeal to the young to the extent that some of it is disposable after one use, they have established a new business model with associated marketing channels.

Financially they have a very high rating as investor enthusiasm for the growth story means they are now on a historic p/e of 53. But there are a whole range of issues that are of concern, some of which are apparent from the Shadowfall report. I particularly focus below on the non-financial aspects because as I say in my book Business Perspective Investing, accounts cannot be relied upon and it’s best to look at other aspects of a business.

Are there any barriers to entry in this business is one key question? Are they doing something that cannot be copied by competitors? Will their profits and profit margins be eroded by lookalike competitors in the traditionally fierce rag trade?

A few years ago, it might not have been easy to set up an internet retailing operation, but now everyone knows how to do it and it does not cost much either. The traditional clothing retailers and supermarkets may be catching up fast even if Boohoo have built a big customer base. But I suspect their customers are fickle, being young and impulsive and might easily be poached by others with lower priced promotions.

Shadowfall points out that one of the company’s competitors is ISawItFirst.com who even appear to be selling apparently identical products. That company is majority owned by the brother of BOO’s Chairman. Another oddity is that BOO owns 66% of PrettyLittleThing with an option to buy the rest. That company is also a competitor and is run by the son of BOO’s Chairman.

The company also acknowledges in its latest announcement that the current board comprises 4 executive directors and 3 non-executive directors, i.e. there is no majority of non-execs as usually expected for larger companies – and BOO is large with a current market cap of about £3 billion.

In summary, this looks like a company for short term speculation rather than long-term investment to me. Not my ideal investment proposition without even looking at their financials and the questions raised on them.

There is also a big risk there will be more bad news about their operations revealed in due course. Once a company comes under a spotlight, any dirt that was previously swept under the carpet tends to be revealed.

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

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Bad News for the Housing Market and On-Line Retailers

The news in the housing sector is all bad. Banks have stopped providing mortgages and builders have stopped building houses (Redrow announced it was closing all its sites this morning). Estate agents are also giving up as nobody wants to have strangers wandering around their house and there are few new buyers. Who would look to buy a house given the economic uncertainty and with everyone’s jobs under threat? Rightmove previously announced it was discounting all its bills to agents but they have now announced that the proposed final share dividend is being cancelled.

Did you think on-line retailers might be able to continue operating? Think again. Next has announced it is temporarily closing its on-line operations including warehousing and distribution. Apparently “colleagues” feel they need to be at home. This mirrors what I have seen from a couple of smaller on-line clothing suppliers I use. They both announced closure in the last few days. Will Boohoo, ASOS and Amazon be able to continue to operate? Only supermarkets seem reasonably sure to be able to stay in business over the next few weeks.

This gloom over the country’s business status was echoed in the comments of Paul Scott on Stockopedia. He said this morning: “Hundreds of £billions in economic activity is being killed off, with ruinously expensive compensation schemes being dreamed up. For what benefit? We’re likely to end up with millions of unemployed, many thousands of destroyed businesses, all of which might have slowed down the spread of the virus a little”. He has lost confidence in the recent stock market bounce and thinks losses will be ruinously high in many companies. I agree with his comments. Certainly in many sectors it’s a question of which companies will survive the year, not whether they will make any profits or pay any dividends.

The only positive glimmer is that Anthony Bolton, who ran Fidelity’s Special Situations fund until 2007 very successfully, is apparently moving back into the market to purchase selected stocks according to an article in the Financial Times. He says “at these prices there are really interesting opportunities”. Certainly the key is to be very selective even if you believe the crisis will be over by the end of the year.

Meanwhile I am sat in the bomb shelter otherwise known as isolating at home. These are such momentous times that I decided to start writing a diary just as my father did during the second world war. It may interest my offspring in due course as reading my father’s diary did after it came to light 37 years after he died. My diary may be a much shorter one though if I catch the virus.

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

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It’s Not Just Blood on the High Street – ASOS et al

The trading statement this morning (17/12/2018) from ASOS (ASC) has caused the share price to fall by 40% at the time of writing. Other internet retailers such as Boohoo (BOO) fell in sympathy.

ASOS reported that revenue was up by 14% over the previous year, but warned that they “experienced a significant deterioration in the important trading month of November and conditions remain challenging. As a result, we have reduced our expectations for the current financial year”.

In effect the previous forecast sales growth for the year of 20 to 25 percent has been reduced to circa 15% (last year it was 25%). In addition margins are down which they blame on a “high level of discounting and promotional activity across the market” which they have reacted to by increasing their own level of promotional activity with more discounting and clearance sales.

They blame the weakening in consumer confidence driven by economic uncertainty plus unseasonably warm weather in the last three months. Weather is normally blamed by retailers for poor footfall in their shops so why should it affect internet retailers? It’s because it allegedly has reduced the average selling price of items purchased. But the really interesting aspect is that it is not just the UK that has suffered. Trading in France and Germany has also become “more challenging” with more promotional activity therefore required.

Note that I do not hold either ASOS or Boohoo although I have done in the past. Before this profit warning, ASOS was on a prospective p/e of 36 for the current financial year according to Stockopedia which I considered rather fanciful even given the high growth rates. Estimates will now be revised down substantially, the company is cutting capital expenditure which is always a negative sign, and they “continue to anticipate returning to a free cash flow positive position in FY20”. In other words they are still burning cash.

So it would seem that the dire stories about trading on the High Street is not just caused by the move to internet shopping. Both High Street and internet traders have been hit by declining consumer confidence, with the former also damaged by high business rates and increased staff costs.

There has been no Santa Claus rally in share prices as normally expected this year. It may be too soon to judge the outcome of all retail sales over the Xmas period but this news does suggest that there will be no Santa Claus effect there either. One has to question whether internet retailers such as ASOS will ever return to the heady 25% annual growth rates. There are too many companies getting in that game because there are no significant barriers to entry. Internet retail start-ups are spending money on marketing on the basis that they will make money sooner or later, but will they? Competition to the likes of ASOS and Boohoo can only increase.

A similar trend is being seen in the on-line estate agent market (Purplebricks et al) where competition is growing, some are giving up after running up losses, and nobody is making money due to high levels of marketing expenditure so as to grab market share.

These are markets where I have no urge to dabble in the shares of such companies at present.

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

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