An investor’s worst nightmare…
Waking up to find what you thought was a perfectly sound company, is suddenly at death’s door.
It seems to be happening a lot. Last July Carillion shares were trading at 200p. Now they are worthless. That’s £850m down the drain.
At the beginning of March you could have got 300p for shares in Conviviality. When they return from suspension, you will be lucky to get 50p. That’s another £450m gone.
But the biggest of the lot is a company you may never have heard of, even though it may have cost you…
UK pension funds invest in index funds around the world, including those that track the Johannesburg Stock Exchange index. Steinhoff was the 11th largest constituent in this index. Now this global retailer, and owner of UK brands Poundland, Harveys and Bensons for Beds, has lost 90% of its value.
That is £11bn we will never see again.
The deconstruction of a giant
If you have a few hours to spare, I recommend watching the web-casts of the Parliamentary Committee into the collapse of Carillion.
Here you will find some great insights into the crazy world of fund management – the MPs struggled to understand why Blackrock was running both a short and long position in Carillion – as well as some entertaining and ignorant sniping from the Committee.
Peter Kyle, Labour MP for the unfortunate denizens of Hove, distinguished himself by asking whether the auditors EY, paid £10.8m for their vain attempt to rescue Carillion, should not have been paid by results?
Since EY’s job is to put together a credible plan upon which financiers can continue to support the business, such a proposal would raise obvious conflicts of interest. Perhaps a better idea would be to pay MPs by results…
But back to Carillion and the key question – could investors have seen this coming?
Evidently plenty did, because not only did big investors like Standard Life sell out before disaster struck, but Carillion was the number one target of short sellers. Not that this caused much concern to Carillion and its auditors, who took comfort from the fact that almost all broker analysts were saying either ‘Buy’ or ‘Hold’.
The same applied to Conviviality as well as that Titanic of all corporate failures, Enron. So there is lesson one. Don’t pay any attention to the analysts, who are either too stupid, too docile or too afraid of offending potential corporate clients to say anything negative.
The irony of sustainability…
The central questions, though, concern Carillion’s latest Annual Report and Accounts (for 2016), which are supposed to give an unvarnished picture of the company’s position.
The first fifty or so pages of this tome are best avoided. Carillion ‘embeds sustainability in everything we do,’ – although not sustainability of the company, obviously.
Carillion’s Chairman Philip Green (who as Managing Director of Coloroll was, in 1994, reprimanded for agreeing that the company’s pension fund should buy the Chelsea flat of Chairman John Ashcroft for an inflated price) assures us that ‘the Group has a good platform to develop going forward.’ Any risks, John?
Well, Carillion had ‘conducted an extensive review to identify the potential impacts of Brexit’ but all things considered ‘the Directors believe that they have a reasonable expectation that the Company will be able to continue in operation and meet its liabilities as they fall due over the three-year period of their assessment.’
No mention then of some dicey construction contracts, in particular one in Qatar where the customer was not happy and was refusing to pay. ‘The Board monitors the level of risk taken on individual major projects using a model known as the Risk Management Matrix…(it) concluded that the level of risk associated with the Group’s principal risks is currently consistent with the Group’s overall appetite in relation to these risks.’
Neither the external nor internal auditors questioned this ‘risk appetite,’ and in the Parliamentary enquiry they performed their usual smooth job of blaming everybody but themselves.
Thus continues the proud history of the Big Four accounting firms which, as Bernie Madoff whistle-blower Harry Markopoulos recorded, have never uncovered a single major fraud although it beggars belief that they can never have been aware of any.
Ultimately, it was a downgrading of the risk appetite from an ‘optimistic view’ that brought Carillion down. Suddenly it faced up to the fact that it was unlikely to be paid what it claimed to be owed, it took a provision of £845m and the end was in sight.
Could outside investors have seen that the directors’ views were too optimistic? Not directly. There are other tricks that are not obviously evident. Carillion used ‘reverse factoring’, whereby its banks settled the bills of its suppliers. This mounting debt to the banks, and the cost to Carillion, was not spelled out.
Another common trick used by Carillion was to bunch supplier payments around the year-end. It is much better to show cash in the balance sheet on December 31st and pay suppliers in January, than to pay them before the year-end.
Tesco also delayed payments to suppliers but, not content with that, it insisted that those same suppliers paid upfront the fees that it demanded for shelf space. Finally, the Trustees of its pension fund agreed that, to try to save the bigger fish that was feeding it, Carillion could suspend pension contributions – an absolutely shameful decision.
Such practices are not easy to discern from statutory financial statements. I agree with David Eaton, a highly experienced financial analyst, that there is a role for a third party who can warn investors of the pitfalls that auditors and broker analysts wilfully overlook. He has set up FraudRiskAnalysis
for this purpose.
The lifeblood of a bullet dodger
When I met David in that haven of global fraudsters, Chelsea, he listed the signals that investors can spot:
1) Reported Profits Should be Backed by Cash
This is hardly new and yet I wonder how many investors look beyond the P&L to the balance sheet and cash flow statements.
2) Beware Goodwill
Carillion’s accounts recorded a literally incredible figure for goodwill of £1.57bn. While you might reasonably say that BMW has a goodwill value, in that you trust the brand, there is little if any brand loyalty in construction. Companies are not obliged to impair goodwill and if they do so, this can damage their ability to pay dividends.
3) Look at Director’s Remuneration
A large element of the remuneration of Carillion’s directors was tied to reported financial metrics or to the share price – a clear incentive to fix the figures.
4) Beware if Pre-Tax Profit is Much Below EBITDA
Conviviality headlined its results with news that EBITDA had increased by 102% to £60.9m. But after some inconvenient expenses like ‘Exceptional Items’ that £60.9m became a pre-tax figure of just £22.4m. Conviviality also had a big deterioration in its net debt and net current assets.
5) Too Many Acquisitions
Acquisitions can make good business sense. But sometimes one company buys another as a short term fix to get its hands on some cash.
Carillion has a history of making acquisitions as, even more so, did Steinhoff. One revelation of the Parliamentary enquiry was Carillion had not properly integrated its acquired companies. Each was still using its own reporting systems, making it impossible for the Group Directors to have an overall picture. You would think the analysts would have found this out.
6) Smooth Talking
The reality of Carillion, said one witness to the enquiry, ‘was at odds with the way it was presenting itself.’ These days, companies are skilled in the arts of smooth talking investors. Chart-filled presentations are knocked up by PR firms, who also have every incentive to keep the rusty ship afloat. And, beware a company that always meets the market’s profit forecasts, especially in an industry as fickle as construction. Life ain’t that easy.
7) R & D
Make sure that a company is spending enough on R&D, especially in a fast moving industry like technology. Reducing this expense swaps short-term gain for long-term pain.
8) Avoid Certain Industries
Unlike institutional investors, individuals can avoid some sectors altogether. Construction is notoriously dodgy, featuring fixed price contracts that can easily be exceeded by costs as the work progresses. There are no barriers to entry, little reason beyond price to choose one firm over another, profit margins are low and the industry is cyclical.
Another industry to avoid is banking. Even a forensic expert like David Eaton admits ‘we do not fully understand some of the financial instruments that they carry on their balance sheets.’ Who does?
9) Management Changes
Successful companies have settled management teams. Unsuccessful ones do not. The departure of the Finance Director (Carillion again) should always ring the alarm bell.
10) Reporting Timetable
Bad figures take longer to add up than good ones. The Stock Exchange demands that Annual Financial Statements are reported within four months of the year-end. Good companies get the job done quickly; bad ones will often wait until the eleventh hour.
Remember – avoiding losses is as important as making gains. Follow these rules, and the bullets will pass you by.