Investors are still reeling from last week’s allegations of fraud at cake maker Patisserie Holdings (CAKE) that saw shares, which had previously been riding high, suspended and its finance director arrested.
The company, which runs the Patisserie Valerie chain of bakeries, said it had “been notified of significant, and potentially fraudulent, accounting irregularities”. The Serious Fraud Office is investigating.
“A material shortfall between the reported financial status and the current financial status of the business” was uncovered, and Patisserie had to be bailed out to the tune of £35 million. Just under half of that came from institutional investors through a share placing, and £20 million from chairman Luke Johnson in loans.
Patisserie is listed on the UK’s junior market, AIM, which is a lesser-regulated exchange that has run into its fair share of troubles since it began in 1995. Many former AIM inmates have mired the index in controversy, though they are rare cases these days.
AIM Failures
None more so than Langbar International, which floated on AIM in 2003 as a cash shell. After its founder Dr Mariusz Rybak was replaced as CEO by Stuart Pearson, shares rose from just 10p initially to a peak of £10.
The company collapsed in 2005 after it admitted it “could not establish the existence” of £370 million it said it had stashed in a Brazilian bank. In the end, Pearson was jailed for a year and Rybak sued for £30 million by shareholders.
Affinity Internet’s flotation in the middle of the dotcom boom, in April 1999 valued it at £12.75 million. The company, which ran two businesses, a mobile phone network operation and a virtual ISP business, peaked at a market cap of £1.9 billion two years later. It went bust in 2003, owing clients BT and Vodafone millions.
More recently, Quindell, a software provider to the insurance industry, was investigated by the SFO for dramatically overstating its results. The firm said it had made a pre-tax profit of £107 million in 2013, but it had in fact suffered a loss of £64 million. The firm’s legal business was bought by Australians Slater & Gordon and the rest of the firm lives on as Watchstone (WTG).
Telecoms firm Globo entered administration in late 2015 and was investigated by the SFO for market abuse, accounts falsification and insider dealing.
Regulation has improved since, says Russ Mould, investment director at AJ Bell. AIM Rule 26 was introduced in response to Langbar 11 years ago, specifying each company must have a freely available website and list certain pieces of information.
Since September, AIM firms have now been required to disclose details of which recognised corporate governance code they follow. “When I started looking at it in 2005, few companies had websites and it was hard to get information, so in that respect there has been enormous improvements,” says Mould.
“Fund managers and investors have policed it themselves, and the LSE has definitely, without wanting to smother it, made sure that there are more checks and balances.”
While rules have been tightened, investors still need to be aware that one reason many companies – think ASOS (ASC), FeverTree (FEVR), Burford Capital (BUR) – elect to stay on AIM rather than move to the main market is the lighter-touch regulation. That’s no reason to be more cynical, but is something to bear in mind.
Not Only Small Caps Falter
While it’s easy to think back and recall the above examples of AIM companies failing, it’s important to note that frauds like this are not confined to small caps.
Take Tesco, for example, says Ian Forrest, investment research analyst at The Share Centre: “One of the biggest companies in the UK and they had this £250 million fraud which is still being investigated now. It can happen anywhere, unfortunately, and it’s almost impossible to avoid.”
And Tesco isn’t alone in being a blue-chip company to have succumbed. “If you look back long enough you find British and Commonwealth, Polly Peck, Maxwell Communications Corporation. It can and does happen even to the very biggest,” adds Mould.
There are measures investors can take to mitigate things. Forrest suggests sticking to the larger, more established names of the AIM 100. But Patisserie was one of those, too. In fact, this particular episode seemed to take everyone by surprise.
It was a company that, on the face of it, was doing extremely well in the face of plenty of consumer-related headwinds. Johnson himself is a well-known and respected entrepreneur who oversaw the rise of Pizza Express, amongst others, and has plenty of ‘skin in the game’, as a 37% shareholder.
Mould says: “There are things you can look for to try and protect yourself, but Patisserie Valerie passed nearly every test. The only thing I’ve been vaguely been able to pick up on is it was almost in ‘too-good-to-be-true’ territory.
“Sometimes, when you can’t find anything fishy, you almost need to benchmark it against comps to see if it’s doing anything that’s off the clock or unusual. There may be a good reason for it, but there may not.”
How Can Investors Spot Red Flags?
It may be near impossible to spot fraud in companies – be that large or small cap – when the alleged perpetrators are intent on carrying it out. But there are things to look for that might help investors avoid mishap.
Firstly, says Mould, checking that a dominant CEO’s interests are aligned with other shareholders’ is key, although Patisserie passed this test. It’s still worth checking whether the executives have skin in the game, though.
Also, be wary of how easily management bonuses are to trigger. If they’re linked to earnings per share growth, for example, “going out and acquiring things is generally a pretty easy way to do it”. Frequent, or transformational, aquisitions should always be considered carefully.
“You always want to look out for the regular appearance of exceptional items in the accounts,” adds Mould. “Unintelligible footnotes are always generally a bit of a giveaway as well.”
Mould also notes some advice he was one given on “the rule of three”. “You always, over time, want to see growth in sales, operating profit and free cash flow pretty much track each other.
“They’re never going to mirror each other perfectly, but what you don’t want to see, which you saw at Carillion, were sales and profit growing but free cash flow going down. That would lead you to think that something funny was going on somewhere in terms of revenue recognition, receivables, inventory or how they’re booking revenues.”
Nicholas Hyett, equity analyst at Hargreaves Lansdown, points to the importance of dividends. Clearly, there are fewer dividend-paying stocks on AIM, as many are either in the growth phase, or are just unprofitable. But these are much riskier.
And recent research from Link Asset Services shows cash being returned to shareholders from AIM companies is now on the rise and is expected to breach £1 billion for the first time in 2018.
Dividends as a Barometer
Hargreaves research, meanwhile, shows that AIM firms that pay a dividend delivered a five-year total return of 156.5%, compared with just 12% for those that didn’t pay a dividend. When you consider that ASOS, the largest and most successful AIM stock around, is in the latter category, that’s pretty impressive.
Hyett says: “Dividends can only be paid out of profits, and since they’re usually paid in cash, they’re a good indicator of cash generation, as well. We also think that the decision to pay a dividend shows that directors have investors’ interests front of mind.
“Clearly, the fact a company pays a dividend is no guarantee of success, and not paying a dividend doesn’t mean a company is doomed to failure. But we think it’s a good initial indicator of quality – and generally helps to keep clear of some of the more dramatic collapses AIM has seen over the years.”
But make sure the dividend cover is healthy, adds Mould. Anything below two times is potentially dangerous.
Finally, Mould cautions against companies that have both high operational and financial gearing. “It’s great on the way up because your sales go up and your profits go bananas. But it can be very dangerous on the way down because as your sales drop very slightly your profits can go down very quickly and you’ve still got to pay your interest bill and tax.”
In the end, it’s all down to due diligence. Of course, when an institutional asset manager goes through the accounts with a fine tooth comb and still can’t spot fraud, there’s not much the lay retail investor can do.
But that’s no excuse for not finding out as much information as possible and questioning anything you don’t understand. “Fundamentally, it is about finding out as much as you can but being aware that, even if you think you know everything, there may well be something that can come out of the blue,” says Forrest.
