How to avoid being ruined by nasty stockmarket surprises

Investors in cake shop Patisserie Valerie got quite the shock last week. John Stepek explains how to avoid that sort of thing happening to you.

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Last week, we learned once again that there are many ways to lose money in equities.

There's the way that most people lose money buying high and selling low. At least some of the people who panic bought when the market was surging will then have panic sold last week when it was falling, turning paper losses into real losses.

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Avoiding that is partly about experience, partly about mastering your own psychology, and partly about understanding valuation.

But there's another way you can lose money in equities, which tends to come as a much bigger shock. This is when a company turns around and reveals that it's not what it seems.

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That's what happened to unfortunate shareholders in Patisserie Valerie last week.

What's going on at Patisserie Valerie?

Patisserie Valerie is a chain of cake shops. It's also turning out to be a quite extraordinary investment story.

In March, Patisserie Valerie said it had £28m in cash on the balance sheet. Last week, we found out that it actually has nearly £10m in debt and was struggling to find a million pounds that it owed the tax office.

The finance director (Chris Marsh) was suspended, then arrested, before being released on bail without charge. Now we hear that the company had overdrafts worth nearly £10m. The board had no knowledge of these.

In short, you've got a massive hole in the balance sheet. It either got there because someone was covering something up, or because they had their fingers in the till. One way or another, it's a disaster for the shareholders.

The good news and given the state of the company, it really is good news is that serial entrepreneur and major shareholder Luke Johnson has loaned the company £20m. There's going to be an emergency rights issue at 50p a share a far cry from the £4-plus they were going for when they were suspended on Wednesday. But at least the near-3,000 staff won't lose their jobs.

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Now I've seen a fair few disaster stocks in my time as a financial writer, and I would say that at least half of them were stocks that any reasonably cautious investor would have avoided or had worries about.

Carillion is a good example that had more red flags than the Jeremy Corbyn fan club. And there are lots of other examples companies where short sellers have big holdings, or "jam tomorrow" stocks where no one is really quite sure what they're selling, except that it promises to be revolutionary.

But this story is different Patisserie Valerie was a very simple business. This wasn't Enron; it wasn't Theranos: It sold cake for cash. That's not a difficult one to follow.

Now I don't know what's gone wrong. I'm very interested to see what comes out in the wash. Johnson has of course, taken a verbal kicking from all and sundry, which is just a risk you run being a mouthy entrepreneur in the UK.

But at the same time, he's done the right thing by the company and this will have hurt a not-inconsiderable chunk of his own money is sitting in this stock. So while it's easy to sneer from the sidelines, all this suggests for me is that if someone is determined to pull the wool, then it can be pulled.

So how can you prevent this sort of thing from ruining you as an investor?

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I hate to say this, but there's a boring solution to this problem

You're probably going to hate this answer, but there's nothing clever you can do, no formula you can use to check these things. It just boils down to that old magic word: diversify.

The financial industry often talks about diversification in quite an abstract manner talking about risk-adjusted returns and asset allocation and the like. But Patisserie Valerie demonstrates vividly why you need to avoid putting all your eggs in one basket.

Things sometimes go pear-shaped, even in what are apparently the best-run businesses. You can't predict the future. You can estimate the odds, certainly. You can improve your chances of beating the market by having a sound investment process that you follow. But every so often, the market will spring a nasty surprise (some might say especially when you're talking about AIM).

So just as we diversify our portfolios between different types of assets (equities, bonds, cash, gold, say), we also need to diversify within the categories. Most people do this by owning funds. But those of you who like to pick individual stocks just need to make sure that you own a large enough spread that you aren't too concentrated in any single stock or sector.

What should you do with Patisserie Valerie now?

The other obvious question now is: should you invest in Patisserie Valerie? The company has been hit by what increasingly appears to be an extraordinary fraud. Now that it has been uncovered and stopped, is there scope for the chain to recover.

For my money, it's too early to tell. On the one hand, Patisserie Valerie appears to be a successful business. It's not my cup of tea, but the shops generally seem to be as busy as any other high street chain, and they seem to be well located too.

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On the other hand, we have no idea what the "real" figures will look like and the fact that we got here in the first place does make you wonder how much of a grip on things anyone else in the business has.

Cautious sort that I am, it's not a gamble I'd be willing to take right now.

What if you hold it already? Well, you already know you're going to be sitting on a mammoth loss when the market opens again. So you've got a decision to make. But the honest truth is that I'm not sure you yet have enough information to make it.

Once we've got the definitive accounts, we'll be able to judge more accurately what Patisserie Valerie "should" be worth. It might take a while to get to that point.

When you do have enough information to make a decision, that decision might well be to "sell" and there's no shame in that. Alternatively, the company might still look good to you, in which case you should buy.

What you shouldn't do, is sit on it, in the hope that it'll go back to £4-plus. It probably won't, and by the time it does, it'll have cost you a fortune in opportunity costs.

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So watch its progress, get an idea of what the stock's new "intrinsic value" is, and then make your decision and stick to it. Good luck.

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