The one way to survive fraud

The hard lesson from the collapse of Patisserie Valerie is that sometimes no amount of research is enough, says John Stepek.

932-PatVal-634

Patisserie Valerie collapsed last week

The hard lesson from the collapse of Patisserie Valerie is that sometimes no amount of research is enough.

Revelations keep coming about Patisserie Valerie, the cake and coffee chain that went bust last week. It now seems highly likely that a huge £40m fraud has been committed, which leaves two main questions for investors: one, is there any way to spot this sort of thing coming? And two, what on earth is the point of an auditor?

In answer to the first question, as Phil Oakley pointed out in Investors Chronicle in October when the problems first came to light, there are often red flags in a company's annual report.

Yet in this case, there were virtually none. Patisserie Valerie was not hugely indebted. Profits were reportedly turning into free cash flow at a decent rate. Many of the usual flashing warning signs that have been obvious prior to other stockmarket disasters (such as outsourcing group Carillion, for example) were not present here, mainly it now seems because the books were being cooked.

Tim Steer, former fund manager and author of The Signs Were There, a book on how to spot companies at risk of collapse, acknowledges that there were "no smoking guns" in the accounts. However, the "financial metrics were strangely different from similar companies", he notes in The Daily Telegraph. For example, Patisserie Valerie had operating margins of 18%, compared with 9% for The Restaurant Group. And stock turnover was surprisingly low, at just 4.2 times a year. "That's a lot of stale cakes."

Dan McCrum, writing on the FT Alphaville blog, adds that sales figures were surprisingly smooth. "Average sales per store barely changed in five years, even as the number of them doubled." In 2014, each branch made almost £600,000 in sales on average. By 2017, that figure had not changed, even though the number of branches had grown from around 130 to nearly 200.

Yet as McCrum also notes, short-sellers who had strong incentives to be on top of this stuff had paid little attention to Patisserie Valerie before the revelation. So while it's easy to spot certain suspicious signs with hindsight, it's hard to disagree with Oakley's conclusion that "it was probably impossible for an outsider to spot if a fraud was being committed".

Of course, this is in theory why we have auditors. We look at their role in this mess, and what might be done about it, in more detail below. But the ultimate lesson from Patisserie Valerie is one of the most basic and boring yet important pieces of advice for an investor to remember: don't put all your eggs in one basket. Regardless of how well you think you know a stock, and how well you've done your research, there are always unknowns. The only way to guard against these is to diversify sufficiently across both stocks and sectors.

What are auditors for anyway?

The problem here, as Grant Thornton's CEO David Dunckley told MPs at a recent hearing, is that "there is a clear expectation gap... An audit fundamentally gives a reasonable opinion on historic information, and doesn't look for fraud". This is the core explanation trotted out by auditors in the wake of other disasters, such as Carillion.

In effect, what people think auditors do (check for fraud or general dodginess), and what they actually do (check for broad compliance with accounting standards) are miles apart, and we shouldn't be surprised when things sometimes go wrong.

Of course, most investors would argue that this implies that we don't demand enough from auditors. And as Chris Bryant notes on Bloomberg, even judged by their current low standards, auditors are failing "more than a quarterof audits reviewed by theUK regulator, the Financial Reporting Council, were found to be unsatisfactory".

Part of this is down to a lack of competition the Big Four accountancy giants (PricewaterhouseCoopers, KPMG, Deloitte and EY) audit almost every single FTSE 350 company and the Competition and Markets Authority has made a number of proposals, including the separation of auditing and consultation services, and a system of "joint audits" for larger companies. But other changes, suggests Bryant, such as moving from a less black and white system of reporting to one where aspects of accounts are rated as "cautious", "balanced" or "optimistic" could help.

Recommended

The giant investment platforms and the risk to shareholder capitalism
Investment strategy

The giant investment platforms and the risk to shareholder capitalism

The fact that so many of us invest via the big investment platforms means that there is a huge dislocation between the owner of the shares (us) and th…
23 Apr 2021
Vanguard's financial advice revolution
Investment strategy

Vanguard's financial advice revolution

Vanguard’s financial-planning product is transparent, cheap and low-hassle. The competition had better watch out
23 Apr 2021
Why investment advice could be about to get a lot cheaper
Investment strategy

Why investment advice could be about to get a lot cheaper

Vanguard, the world’s second-biggest asset manager, is launching its own cut-price financial advice service. It’s something the industry badly needs, …
20 Apr 2021
The FTSE 100 has clawed back above 7,000 – how much higher can it go?
UK stockmarkets

The FTSE 100 has clawed back above 7,000 – how much higher can it go?

The FTSE 100 index has risen to over 7,000 for the first time in over a year – it now sits just above where it was in 1999. But its era of neglect cou…
19 Apr 2021

Most Popular

China owns a lot more gold than it’s letting on – and here’s why
Gold

China owns a lot more gold than it’s letting on – and here’s why

In a world awash with money-printing, a currency backed by gold would have great credibility. And China – with designs on the yuan becoming the world’…
21 Apr 2021
“Joke” cryptocurrency dogecoin goes to the moon. What’s going on?
Bitcoin

“Joke” cryptocurrency dogecoin goes to the moon. What’s going on?

Dogecoin – a cryptocurrency created as a joke – has risen by more than 9,000% this year alone. Saloni Sardana looks at how something that began as an …
19 Apr 2021
House prices in the UK are still surging – here’s why it’ll probably continue
Property

House prices in the UK are still surging – here’s why it’ll probably continue

The latest UK house price data shows no letup in the country’s booming property market, with the biggest yearly rise since 2014. And there’s no end in…
22 Apr 2021