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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