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

Robin Geffen: dividend cuts aren't all down to Covid
Stockmarkets

Robin Geffen: dividend cuts aren't all down to Covid

The seeds of recent dividend cuts and cancellations were sowed many years ago, says veteran investor Robin Geffen.
25 Oct 2020
Dividend payments will take a long time to recover
Income investing

Dividend payments will take a long time to recover

Companies are gradually resuming dividend payouts, but we can expect only a modest rebound in 2021, says Cris Sholto Heaton.
25 Oct 2020
Buying bitcoin could be the best way to play the remote working boom
Bitcoin

Buying bitcoin could be the best way to play the remote working boom

The coronavirus pandemic has accelerated the move to home working, flexible employment practices and the rise of the “digital nomad”. One of the best …
21 Oct 2020
Great frauds in history: the Independent West Middlesex Fire and Life Assurance Company's early Ponzi scheme
Investment strategy

Great frauds in history: the Independent West Middlesex Fire and Life Assurance Company's early Ponzi scheme

The Independent West Middlesex Fire and Life Assurance Company (IWM) offered annuities and life insurance policies at rates that proved too good to be…
21 Oct 2020

Most Popular

Negative interest rates and the end of free bank accounts
Bank accounts

Negative interest rates and the end of free bank accounts

Negative interest rates are likely to mean the introduction of fees for current accounts and other banking products. But that might make the UK bankin…
19 Oct 2020
UK post-Covid recovery stocks: these 20 companies could be set to rocket
Share tips

UK post-Covid recovery stocks: these 20 companies could be set to rocket

Finding stocks with the potential to rise tenfold or even further is far easier said than done. But the pandemic has produced the most promising backd…
22 Oct 2020
Why commodities could be the best investment for 2021
Commodities

Why commodities could be the best investment for 2021

There’s plenty for investors to worry about right now. But things will inevitably recover. And the sector most likely to do best when they do, says Jo…
22 Oct 2020