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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Coronavirus Impacts – Victoria, Auto Trader and Bowling Alleys

Stock market investors are clearly becoming nervous again following a rise in Covid-19 infections in the UKA – particularly in the Southern and Western states. This has affected the US stock markets and, as usual, it has affected UK markets in sympathy.

There were two announcements this morning that were interesting as regards the impact of the virus epidemic and the resulting “lockdown” of the population. Home working has become more normal or people have been “furloughed” or permanently laid off.

Victoria (VCP), a manufacturer of floor coverings, had to close their factories but they have all now reopened. Their customers are mostly retailers and many of them had to close but are now reopening or already have done. The company says group revenues for the last three weeks are now at 85% of pre-Covid-19 budgets.

Interestingly they say this in today’s trading update: “It is important to remember that 93% of Victoria’s revenues are derived from consumers redecorating their homes, not construction or commercial projects, and consumer demand for home decorating products appears to be strong across the world. This is not altogether surprising, given the extended period consumers have spent in their home over the last four months, which is likely to have encouraged the impulse to redecorate”. Clearly it’s time to do some DIY jobs.

Auto Trader Group (AUTO) announced their final results for the year ending March 2020, which contained an update on current trading. They provide a web portal for car dealers, who all had to close. Auto Trader provided free advertising in April and May plus a 25% discount in June. As a result they lost money in those months. The company has also chopped the dividend, cancelled further share buy-banks, did an equity placing and used the Government’s Job Retention Scheme. A vigorous response in essence, rather like that of property portal Rightmove.

Car dealers are reopening but for most you cannot just walk in to the dealer. You have to make an appointment. This encourages web shopping for a new car which is to the advantage of Auto Trader. The company announcement (and what was said in their web cast which was otherwise somewhat boring as it consisted mainly of reading a script), was generally positive but it leaves a question as to how soon car sales will recover. They don’t seem to be losing many dealers and dealer stock figures are what matter rather than sales. But dealers’ revenue and profits might come under pressure as many car purchases can be postponed. Cars do wear out of course, but with mileage reduced as there were, or are, few places open to go to and more home working is taking place, this could reduce car sales.

This is therefore a company where one needs to look to the future and how they can capitalise on the trend to shop for cars on the internet, like one might shop for groceries or clothes of late. One competitor mentioned in the conference call was Cazoo who sell (or lease) cars directly on the internet. No test drives or inspection first. You just get 7 days to trial it before acceptance. This is clearly a different business model that might affect traditional dealers although they also provide service of course and concentrate on new cars which is a more complex sales process. There may also be an issue of trust when using an on-line service. But the process of buying and selling cars certainly needs simplifying from my last experience of doing so.

At least bars and restaurants can reopen, albeit with severe restrictions on social distancing. That will certainly reduce their sales volumes and increase their costs, resulting in a big hit to profits. Still a sector to avoid I think.

Bowling alleys were expecting to be able to open from the 4th July based on what Ten Entertainment (TEG) and Hollywood Bowl (BOWL) said. But the recent Government announcement has put a stop to that along with the reopening of gyms and swimming pools. They now hope to reopen in August.

Is this ban rational? I can see why indoor gyms might need to remain closed. A lot of heavy breathing and sweating in close proximity. But bowlers don’t exert themselves much from my experience and if alternate lanes were used social separation would be good so long as they used their own shoes.

Note that I hold shares in some of the above companies. But thankfully not in Wirecard which I previously commented upon and which is now filing for bankruptcy proceedings.

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

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How to Spot a Fraud (Wirecard)

There was a very good article on Wirecard by fund manager Barry Norris on Citywire yesterday. It was headlined “Wirecard raised more red flags than a communist rally” and explained how he thought it was probably a fraud as long ago as March 2018.

He met the former CFO of the company Burkhard Ley in that year but he seemed unable to answer the basic question of “Precisely from which activities did they generate revenue”. One particularly telling comment from my knowledge of the payments sector was this: “When pressed for a specific response on how much of the company’s revenues came from online pornography and illegal casinos, Burkhard claimed ignorance and just grinned, like a well-coiffed cat who not only had just had the cream but who had also just eaten the family pet hamster”.

The Financial Times published allegations about false accounts at the company in January 2019, and again later. But the German financial regulator took no action and even banned short selling of the company’s shares.

Another very negative sign was in early 2020 when the company raised more debt even though it had high profits margins, limited capital expenditure, paid minimal dividends and according to its accounts was generating cash.

The latest news is that former Wirecard CEO Markus Braun has been arrested based on allegations of false accounting.

What can be learned from this case? Firstly that company management who are reluctant to answer detail questions about the business are not people you can trust. The bullshitters who wish to talk about market dynamics and their position in a hot sector rather than the details on how they actually make money (i.e. the business model) are particularly suspect. Secondly that accounts cannot be trusted – not even the cash figures even though they should be simple to verify. See also Patisserie and Globo for examples of where the cash was simply not there. Where there are international businesses with multiple auditors involved, they are even more likely to be unreliable.

Frauds rarely come out of the blue but there are warning signs much earlier than the final disclosure of unexplained problems and company collapse. So it took 4 years at Wirecard for the truth to be generally acknowledged even though issues with the accounts were widely publicised. Why did investors stay faithful to the company? Because investors are always reluctant to admit to their own blind faith in the business particularly when the share price has handsomely rewarded them in the past. People do by nature trust management of companies when the correct approach should be the contrary. Charismatic leaders who dominate their companies are frequently the ones to be wary about.

But it’s never too late to change your mind about a company and sell. A reluctance to sell on negative news is a common psychological trait – it’s called loss aversion. Wirecard investors certainly had plenty of opportunity to do so.

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

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Wirecard Cash Missing and Black Reparations

I always have pleasure in reporting major accounting frauds as it backs up the argument in my book Business Perspective Investing that the accounts of companies cannot be trusted and you need to look at other things to judge the quality of a company. But investors in German payments company Wirecard will be very disappointed that €1.9 billion has gone missing. It seems that information on “spurious cash balances” had been provided to their auditors (EY) by a third party (a trustee supposedly holding it).

The Financial Times has been running a series of articles over several months questioning the accounts of this company, but the shares are now down another 50% and it raises questions as to whether the company can survive.

Another story in the FT today was of organisations such as brewer Greene King and the Lloyds insurance market offering donations to charities supporting “diversity and inclusion” and were apologising for their past involvement in the slave trade. That’s for events before 1807 in Britain and 1865 in the USA when slavery was abolished. Greene King left the stock market in 2019. I just hope none of the companies in which I hold shares participates in this nonsense. Trying to rectify historic wrongs from 200 years ago is just unrealistic and totally unjustified when the persons affected are long dead. History is full of past injustices and it’s simply impossible to compensate for all of them.

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

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FairFX AGM Report, Woodford Fund Issues and Zero Carbon

Firstly a brief report on the Annual General Meeting of FairFX (FFX) which I attended today in the City. Only I and one other shareholder asked any questions, and there may not have been many others there.

This is a payments company which had an initial focus on the provision of foreign exchange but they now do a lot more. They are planning to change the name in the near future and there was a resolution tabled to change the articles to enable them to do this without reverting to shareholders. I abstained on that because I prefer companies to put a change of name to investors. But talking to one of the directors after the meeting it sounds like they are taking a professional approach to the name change.

Revenue of the company was up 69% last year to £26 million with profits of £2.6 million. Adjusted EBITDA was up 687% if you wish to look on the bright side. There was a positive AGM announcement with phrases such as “a strong year to date” both in revenue and margins. Full year trading should be in line with market expectations.

The accounts of payment/credit card companies can be complex as I know from being a director of one of them in the past. So I asked a few questions on that area.

FairFX now exclude customer deposits from their accounts which is a definite improvement. But it does capitalise a lot of software development – £4.7 million last year, which I have no concerns about so long as it is in accordance with accounting standards. In response to a question I was told this level of expenditure might be a bit more in the current year. They are building a new unified front end on their 3 applications (platforms) – some of which were acquired.

I queried the collateral requirements of financial institutions they deal with (see page 6 of the Annual Report) and was told this is taken out of the cash figure on the balance sheet and is now in “Other receivables” – hence the large increase in that figure plus the impact of acquisitions on it and general increase in turnover.

Wirecard was mentioned during these questions. Apparently FairFX has historically used them as a “Card Issuer” but they now have the capability to issue cards themselves which will improve margins – customers will be migrated over. That’s reassuring because Wirecard has been getting some very negative publicity in the FT lately.

The other shareholder attending asked about the economic trends and their impact. Corporates are apparently sitting on their hands re FX and clearly Brexit risk might be impacting the demand for personal FX credit cards as holidays in Europe might be impacted by the uncertainty. However the CEO seemed confident about the future.

I might sign up for one of their “Everywhere” Pre-paid Credit Cards which looks cheaper than the company I am using at present.

This is one of those companies that has stopped issuing paper proxy forms – promoted by their Registrar Link Asset Services. I complained about that. I was also not happy that the resolutions were taken on a poll rather than a show of hands. But I understand the proxy counts were all higher than 99% so that was an academic issue.

Link acting as ACD for Woodford Funds

Link, in the guise of “Link Fund Solutions”, also got their name in the FT today over their activities as the Authorised Corporate Director (ACD) of the Woodford Equity Income Fund. An ACD is supposed to ensure that a fund sticks to the rules. They would have been involved in the decision to close the fund to redemptions.

It also seems very odd to me that they approved the listing of some fund holdings in Guernsey to get around the limitations of unlisted holdings. That was clearly an abuse as the reality was that these were not listing that provided any significant liquidity, with minimal dealing taking place. It’s the substance that counts, not how it might simply appear to meet the technical rules.

This looks to be yet another case of those who are supposed to be keeping financial operators in line not doing their job properly. But ask who is paying them.

FT article on Net Zero Emissions

I commented previously on Mrs May’s commitment to go for net zero carbon emissions by 2050. I called it suicidal.

There is a very good article on this topic in the FT today by Jonathan Ford (entitled “Net Zero Emissions Require a Wartime Level of Mobilisation”). The article explains how easy it is to get to the £1 Trillion cost mentioned by the Chancellor on required housing changes alone to remove all fossil fuel consumption. There may be some payback from the investment required but the payback period might be 37 years!

The whole energy system will need to be rebuilt and some of the required technologies (e.g. carbon capture) do not yet exist on a commercial basis. For more details go to the web site of the Committee on Climate Change and particularly the Technical Report present here: https://www.theccc.org.uk/publication/net-zero-technical-report/

If this plan is proceeded with there are enormous costs and enormous risks involved. But it will certainly have a major impact on not just our way of lives but on many UK companies many of which consume large amounts of power. That is definitely something investors must keep an eye on. Companies like FairFX may be one of the few that are not affected in a big way as they only manufacture electronic transactions. That’s assuming the rest of the economy and consumers are not too badly depressed by the changes as a result of course.

Nobel prize winning economist William Nordhaus has shown how a zero-carbon target is unwise. See this note for more information: https://www.econlib.org/library/Columns/y2018/MurphyNordhaus.html

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

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