This could be a year of nasty surprises for growth investors – but not necessarily the ones that come from central banks. Instead, tightening credit might uncover some very company-specific risks. Patisserie Valerie could be the first of many; a long bull market has bred bad habits. Increasingly, management and boards are adjusting earnings away from recognised accounting standards – flattering growth.
That only works when a buoyant economy, or takeovers and fundraising, can paper over the cracks. Now slower global growth is making it harder to disguise weak business models – exposing bad accounting and governance. This year, investors looking for sustainable growth should focus on governance, incentives and company accounts.
Environmental, social & governance (ESG) tends not to be seen as critical to short-term investment performance. But, it can prove a useful tool in spotting the flaws in a business model. Recent surprises on governance, such as Metro Bank* – have triggered sharp share price falls. Often, further fundraising is needed just when management credibility is at a low. Spending more time reviewing governance, and integrating it with overall investment analysis, is no longer just “nice to have”.
ESG is a lens that can spot a pattern of risky behaviour. Typically, encouragement to flatter earnings comes from incentives that focus on the wrong things, permitted by bad board governance. Academic research has noted that executive pay tends to be higher when adjusted numbers are used. Rewards can be generated by numbers that management can themselves influence, with little relationship to audited profits, cashflow or dividends. It looks a lot like being able to mark your own homework. Bad practice develops when there is no effective challenge to management.
This could be the year that banks and stock market investors decide not to pump more cash into questionable business models. The emergence of network effects – where winner takes all - has encouraged a belief that fighting through years of losses to get scale always pays off. In some sectors, the fight for dominance will end in tears.
Audited numbers usually rely on management projections, particularly if goodwill is involved. Companies can build-up goodwill on their balance sheets, rather than hard assets, when they buy businesses based on people, brands or intellectual capital. Or even when they spend money that they like to think of as an investment. With more of the economy now operating this way, goodwill supported by management judgement is now prevalent in many sectors. And, when banks lend against that, any unwinding of management expectations can trigger disaster. Writing-down goodwill can breach borrowing covenants, as can lower “adjusted” earnings.
Some of the flaws in management incentives are simply using metrics like adjusted EBITDA (earnings before interest, tax, depreciation and amortisation). But there can be more complex and subtle issues, too. These can only be understood through careful reading of the Remuneration and Audit Committee reports. And, as Patisserie Valerie showed, analysts can gain useful insight by pulling up subsidiary accounts from Companies House. Auditors may not be able to check the adjusted metrics that drive bonuses, but they can highlight just how much management judgement has been involved in the projections and value of goodwill and inventory. Now that goodwill is tested for impairment, changes in value can be sudden and dramatic.
Even without interest rate rises, a liquidity squeeze would make capital more expensive this year. Investors and banks may be sceptical if a company is burning cash with little to show for it. Alignment of management objectives and shareholder interests is key. In 2019, investors might usefully spend more time analysing accounts and governance.
A version of this article was published on Trustnet on 21/02/2019.