In an article posted on our website on 15th May entitled “What matters more in investment today? Financial accounting or ESG?” I expressed my disappointment at the declining quality of many cash flow statements. In my view “they are not ‘audited’ in the traditional sense i.e. checked or verified in the way anyone might reasonably expect”. I get an increasing impression that accounting firms are too accepting of what managements tell them about cashflows in and out. In conclusion, I wrote “In the end it boils down to knowing your managements and using your best judgment that the companies to whom you are entrusting your clients’ money are run ethically. Financial statements may give you a broad brush, but you cannot rely on them wholly. Looking at how a company treats its clients, employees and shareholders in practice is an essential part of investment analysis”.
This looks timely in view of recent scandals concerning Wirecard, the German quoted electronics payments business, which has now gone into administration, and Boohoo, the UK fast fashion online retailer that manufactures domestically, whose shares collapsed last week. We cannot guarantee that we will avoid every bad apple but Aubrey’s fastidious ESG process does rule out most, and it did rule out these particular companies.
In fact much of the follow-up dialogue between ourselves and companies these days surrounds ESG matters. The financials are mainly a given, i.e. we replicate our own in-house bespoke financial analysis across every stock we hold, but we remain somewhat reliant on the auditors to confirm that the accounts represent a true and fair view. Over and above that we must have confidence that the people running the businesses we invest in are ethically minded because that is the only thing which provides for a sustainable business. You can cook the books for a period of time, or engage in poor practices, but eventually you get found out, even by lackadaisical auditors, not to mention investigative journalists aiming for a scoop.
These blow-ups are a timely reminder of the necessity for vigilance. We participated in a small group meeting with Wirecard’s CEO at a conference in London in November 2009, when it emerged in the questioning that the origins of the business had been in processing payments for on-line pornography, amongst other things. Although there were vague reassurances given that this no longer was the case, it sowed an initial seed of doubt as to the business ethics of the company and on the first share price wobble in March 2010, when the company’s earning disappointed, we exited the position. We continued to follow the company however, and met again with the CFO, Burkhard Ley, in November 2011. However, we had concerns that their accounting was aggressive. We felt they were overstating their earnings to the tune of about 20% which made their shares less good value than the prevailing P/E suggested.
It is frustrating for investment managers when a share is rocketing higher, as it did for Wirecard between 2016 and 2018, that they cannot invest in the stock. We understand why some investment managers turned a blind eye to the accounting concerns, which were no secret, and joined the bandwagon. But for Aubrey, that was just not a risk worth taking.
Likewise there were always doubts in our mind about Boohoo. The company produces very cheap, disposable fashion for a mostly young female client base, which is neither environmentally nor financially sustainable, unless it can be produced even more cheaply, or, as we have subsequently discovered, by paying employees well below the minimum wage, in working conditions which put their health at risk. This was apparently an open ‘secret’ in Leicester, or even no secret at all, just ‘open’, except to the stock market!
These were relatively easily avoidable investments, assuming you were not blinded by the (overstated) financials or rocketing share prices. But what about other companies in our portfolios in similar lines of business? How do we assure ourselves that they do not have similar skeletons in the closet?
There is no fail-safe method and it boils down to knowledge of the companies, their management and processes and continuing dialogue. We have been in contact with Adyen, a Dutch quoted payments processor in which we are interested, to ascertain whether they might be subject to the same type of fraud that afflicted Wirecard. There are differences in the business model which make this less likely. Adyen’s business has been built on a single platform, organically, over 13-14 years, by a group of developers who put everything on the same technology ‘stack’. This allows for better oversight as well as higher authorisation rates. Most of the competitors in this industry have built their businesses through acquisition leaving the back-end more fragmented. This results in a slower pace of innovation and more difficulty in connecting data sources. Our understanding is that Wirecard worked with a number of third-party processors or partners and was reliant on them to report cash balances, whereas all Adyen’s businesses are fully audited entities. In addition, Wirecard was active in merchant acquiring in the small and medium enterprise sector in Asia, which is not a target area for Adyen, which is more focussed on large scale enterprises.
What about the clothing industry, where various well-known brands have been caught up in sweatshop scandals over the years, well before this latest one with Boohoo? Our European portfolio has no exposure to the sector, but we did seek out the opinion of luxury goods company Kering, which we know takes ESG seriously. Kering monitor their factories, suppliers or sub-suppliers to see that they are being paid at least the minimum, if not the ‘living’ wage in each country, work in reasonable conditions, what rules are in place around social distancing during Covid 19, what systems they have for spot checks on factories and how often these are carried out. The company has extensive and detailed policies regarding labour practices. Just over 90% of their production is in Western Europe and 84% in Italy, which is subject to collective bargaining agreements, a major positive. In 2019, 3,441 audits were conducted on 56% of Kering’s suppliers. Over the 2015-2019 period, 83% of their suppliers have been audited, which is less than ideal, but the group has undertaken to audit all its key suppliers every two years. Suppliers that are on improvement plans are, we are told, audited more frequently. We have had sight of the reopening plan for Gucci’s prototype operations for leather goods and shoes under an agreement signed with trade unions, to restart activities with maximum safety for employees. It is wholly comprehensive and not lacking in any detail. Assuming it is adhered to, employees can be satisfied that their return to work will not compromise their health. Whether such measures are being adopted across the whole group we cannot confirm, but the indications are that the company is taking the health of its employees seriously.
As I said above, there is no fail safe guarantee, but eternal vigilance on ESG, part of our process since we launched the strategy in 2008, goes some way to protecting investors’ interests.
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