Capital Markets: The dangers of swimming naked

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It was Warren Buffett who said that it’s only when the tide goes out that you find out who’s been swimming naked.

This mantra is of particular relevance in the current climate with a weakening UK economy prompting a slew of high profile blow-ups on the stock market.

Although these have been for a multitude of reasons (Carillion and Interserve – a challenging outsourcing market; Conviviality Retail – over-expansion; Patisserie Valerie – suspected fraud; Carpetright – people not moving houses), incidences of negative shocks are definitively on the increase.

EY – who track this sort of thing – saw their Profit Warning Index reach 87 in the final quarter of 2018 where zero represents the lowest reading of warnings since 2007 and 100 the highest. Where 2018 left off, 2019 has continued in the same vein.

On our doorstep, York-based Gear4Music saw its shares hammered in January after suggesting margins would be lower than expected.

So, why is it that companies are disappointing or even failing all of a sudden? After all, UK GDP still grew by an estimated 1.4 per cent last year, a slowdown on previous years but still a long way from recession.

At this point, it is worth examining the Buffett mantra in a bit more detail. In the good times, a growing economy can cover up a multitude of sins brewing below the surface.

As long as a company appears to be growing – and meeting analysts’ expectations – everyone is happy. To compound matters, investors get drawn in to a virtuous cycle of rising prices, profits and money inflows and start taking more and more for granted. It’s human nature. If at this point you are thinking professional fund managers are paid enough to ask the right questions of management you’d be right. But many don’t.

A cautionary tale is Patisserie Valerie’s £15m emergency fundraise in October. The investors who took part have seen their cash evaporate in less than six months without the shares even returning to trading. Some are now threatening legal action although that won’t be straightforward. No-one held a gun to their head forcing them to buy the shares.

With further disruption likely to come in the form of Brexit, I am confident that this run of negative shocks is here for the foreseeable future. Interestingly, whilst it was the Retail sector that grabbed the headlines last year (House of Fraser, HMV, Maplin to name a few), the contagion appears to be spreading to other sectors of the economy be it Financial Services (Metro Bank warning last month of an accounting error affecting the risk profile of some of its commercial loans), Airlines (Ryanair witnessing lower fares over winter, Norwegian announcing a £270m emergency fundraising) and even Technology (Sheffield-based Zoo Digital has halved from last year’s peak on the loss of a significant project). These really are tricky times.

Can investors avoid these blow-ups? The short answer is no. Something like fraud is hard to spot from the sidelines when even the insiders missed it.

But looking out for certain attributes can be helpful. Whilst all businesses will be prone to their ups and downs, both specific (relating to their own business) and systematic (those relating to wider factors), the best businesses prepare for the downside to mitigate any damage.

Having a strong balance sheet with cash or access to additional capital should be the first line of defence to weather uncertainty. But even this isn’t fool proof: a glance at Patisserie Valerie’s last published interim accounts showed supposed net cash of £28.8m, enough you’d think to weather most storms.

Scrutiny of working capital, i.e. how quickly the business is paying its bills and getting paid, is always informative, especially when comparing against peers operating in the same industry. One thing that should have raised a red flag at Patisserie Valerie was the size of its inventory against turnover: should a business primarily selling perishable food and drink really hold 90 days worth of stock when other food shops (such as Greggs and Restaurant Group) typically hold no more than one week’s?

All this is of course easier with the benefit of hindsight and, as the saying goes, you live and learn.

But with the key year end reporting season set to kick off in earnest over the next few weeks, the tide is definitely out and there will be more nakedness to come.