Small Earthquake

Full year corporate accounts have now all been published, in several cases even read, so it is time to look at the raw data beneath all those clever funds and derivatives, at the underlying companies.

There are two themes emerging: one is the extraordinary scale of movements last year in defined benefit pension assets and liabilities, and the other is how we should evaluate the size of the Scottish discount.

Pension Asteroids Collide

Enormous numbers are shifting on defined benefit pension schemes, nearly all the big ones seeing asset losses of several billion, but with matched declines in liabilities of the same scale, leaving almost no apparent change, all stitched back together. This impacts in particular the big banks, utilities, resource majors and of course life companies.

It is a source of some nervousness, when large numbers crash about the balance sheet, dwarfing the trivial numbers in the profit and loss account. But they are also quite different items, the asset declines (from long dated gilts) are real money, stuff you could have woken up at the start of the year, picked up a phone and sold.

Yet the liabilities in terms of actual money to retirees hardly shifted, it was just discounted differently. While nearly all (91%) of the 5,000 odd UK schemes are either Closed To new members (CTNM) or to future accruals (CTFA). So, of little current relevance to operations.

From: This page on the UK Regulator’s website – the key to the abbreviations is also there.

What is relevant is the sudden loss of tens of billions of pounds ny these pension funds. But that is ignored, because of the liability offset, but it was lost and is gone. This came along with dramatic changes in the value of the gilts they hold, in cases by more than the unit value decline, as gilts were actually being sold quite hard too - a big chunk of assets that no longer exists.

Scottish Exceptionalism

So, to the Scottish discount. What is it? In our valuation models we discount earnings for political and operational risks, including for governance, including the location of the auditors. It is an internal assessment, so matters not a jot, unless others do the same.

We know the discount exists, the reversing tide of “swimmers” or companies raising money outside their domestic market, tells you the entire UK is already at a fair old discount to the US, even for companies with mainly US earnings. Should the same apply to Scotland? And by how much more? 20%? Whatever it is, it is getting bigger for us.

In my view if you are a FTSE100 Company, you have big four auditors, London office. Regional offices and smaller firms will be more dependent on a single big client and in enough cases to matter, that disproportionate power will swing it, for the Board, against the investors. Not that London based Big 4 is perfect (we know they are not).

So, to Scotland, there is a long-standing assumption they will use Scottish audit offices, and a drift to using Scottish firms too. This used to mean high quality, but I now sense they lack experience. Boards have also increasingly become reliant on a smaller pool of candidates, and two recent high-profile cases leave me wondering about their governance.

1.   Scottish Mortgage Investment Trust

We sounded the alarm on the peculiarities of this popular fund two years or so ago, in their glory days. Like some other troubled funds, they took on more and more unquoted holdings. All disclosed and approved, but in the end clearly linking private and public markets, indeed boasting of how many of their quoted holdings started out as private ones. Well, a closed IPO market knocks that bet pretty hard. When a lot of them are also Chinese, that renders that pipeline even more suspect.

While disclosed, yes, but adequately disclosed? In one case they hold G, I, H, A, C, B Prefs and A Common Stock, with greatly varying valuations by class. We were nervous, when the share price failed to discount these holdings, at a time when other equity trusts, indeed private equity specialists, were facing growing discounts on their holdings.

That has now corrected, the Board has finally stood up to the manager and questioned the existence of the in-house skills to back up these valuations. But in the process our Scottish discount opened up.

From a three year high of over £14 per share, SMIT has fallen hard to just over £6, wiping out half the value or the thick end of £10bn, from presumably mainly UK retail holders. It has kept falling. I think it will need to list those unquoteds separately, and give holders a share in each asset pool, to regain its once illustrious crown.

2.  John Wood Group

The John Wood Group, which operates in natural resource consulting and contracting, has been a disastrous investment. A well-respected consulting firm, its Board decided to merge with another well-respected quoted consulting firm, Amec: outcome? Hugely negative. Five years ago, its shares were over £5 and even quite recently shareholders were hoping a private equity bid would rescue them after only a 50% loss.

But having overseen that catastrophe, the Board seemed not to be listening. They only very reluctantly agreed to bid talks, and somewhere in those talks something persuaded the bidder to back off. From the bid inspired high of £2.55, it has now virtually halved again. The Board feels old style, out of date, insular. I particularly enjoyed (it is one of the few pleasures of reading so much verbiage) their illustration for the diversity report, (see below).

Extracted via screenshot from the Annual Report and Accounts of the John Wood Group

This reminded me of sitting on a School Curriculum Committee (see the fun I have). We had to cover multiculturism, and the teacher (in the high pale Cotswolds) chose India; intrigued I asked why? The answer was that allowed the topic to be covered for our forthcoming Ofsted inspection, by having a takeaway meal in class. That was it. No map, no history, no people, just an affiliated consumable.

But nice money for the executives, look at last year’s bonus structure. That odd picture served them well. For an original business that is now itself worth nothing and half of what it paid for Amec !

Now, but for that Board, or that history, Wood looks a nice business, cleaned up, $5 billion of apparently profitable sales, with a market cap of £1 billion, not a lot of debt, all three divisions profitable at least at the EBITDA line. Heavily exposed to renewables, including in North America, it even reports in dollars. You could argue the bid was low - no doubt the Board did - but if the price then halves, after the bid vanishes, how credible are they?

So, in comes the Scottish discount – because this pattern of behaviour speaks of a particular culture and leaves me feeling the need for a bigger safety margin, to buy a business from that region.

by Charles Gillams