Fool's Eye View

[ November 29, 1999 ]

An Education in Stock Picking

By Maynard Paton (TMFMayn)

Mistakes. We all make them -- and when it comes to share selection, everyone has a skeleton or two in their closet.

Over the last year, I don't think I've done too badly in my share selection. Out of the six "buy" decisions since January, only one, at the time of writing, was a distinct mistake. The other five selections have either been sold at a profit, or are still showing a paper profit. Sorry, no more boasting.

(But was I boasting, though? After recent weeks, my performance seems mediocre compared to some. Look at this quote from a certain "hot-stock" board.

"I too suffer from 'riseritus' having only been actively investing for 4-5 months. I'm only in four shares but they show gains of 100%, 30%, 300% and 450% as of this morning. Am I gifted? Almost certainly not!")

With the market doing well during 1999, was it my stock-picking ability or was I just riding the wave? I like to think it was the former and that I'd moved up a gear of investment performance. Having said all this, my record prior to this year was, err... patchy, to say the least. Was 1999 a one-off? Time will tell if my "buys" of this year were prudent or not...

So onto the mistake. Hands up -- it was totally my fault. No newsletter, friend nor anonymous message board tipster had suggested it. The company in question was Nord Anglia Education (LSE: NAE). As they reported their full year results today (on which I will offer no comment), I thought I'd relive this sad investment tale. Not least to re-emphasise to myself the lessons learnt.

OK, so why Nord Anglia? Well, I was looking for growth industries. And one area I considered ripe for significant private sector profit growth was Education.

I thought of Tony Blair and his "Education, education, education" mantra. I thought of Tony's election promises about improving the nation's schooling. I saw teaching unions on television protest about the ever increasing "privatisation" of the UK education system. I read in the newspapers about schools and Local Education Authorities outsourcing some functions to the private sector.

No doubt about it, I thought -- the business of education was a growth story. I had visions of all the extra government money flowing into education and how it could all turn into profit for well placed businesses.

Nord Anglia described itself as "an established provider of education and related educational services". All things education! A quoted company with a very convincing growth story...

Of course, I wasn't going to dive straight in. I had to look at the financials and consider the company's valuation. But the growth story was always at the forefront of my mind...

I perused Nord Anglia's flotation document (they floated in 1997) and both their subsequent annual reports. The usual number crunching followed. I concluded that the short financial record since flotation wasn't exceptional.

An acquisition during the summer of 1998 clouded the financial investigation. Largely using its then highly-rated shares, Nord Anglia purchased EW Fact plc for £18m. Announcing the acquisition, Chairman Kevin McMeany described EW Fact as having a "significant impact" on future EPS. In the annual report that followed, I noticed a string of accounting adjustments and a restatement of profits when reporting the EW Fact acquisition. But I thought nothing further of it. The adjustments just didn't register. Remember, I had visions of industry growth to consider.

EW Fact, a professional and academic training company, completed Nord Anglia's strategy. Nord Anglia now had operations in every education sector. The growth story was still intact. OK, the historical financial performance was not exceptional -- but I considered the future more important. The earnings multiple and forecasts at the time didn't seem too demanding. It was time to buy. I was in at 166p in late January 1999.

And what timing! Within four weeks the share price had risen to 280p -- a near 70% gain! Of course, I had been joined just a week later by an "illustrious" stock market commentator. He shared my view over Nord Anglia. It was Malcolm Craig and his tipsheet, "Stock Market Confidential". He had tipped Nord Anglia. (As an aside, TMFFatBlokeMarge gives a good Foolish mauling of this newsletter in this post.)

Should I have sold? Oh no, I was long term -- five years at least. Although 280p looked pretty overvalued in the short term, I held firm. I remember at the time thinking I had this stock-picking game sewn up. Self-proclaimed "King of Stocks", that was me.

Moving into May, my delusions of grandeur were shattered.

Nord Anglia issued a profits warning. Aargh! I read the Financial Times' report the next day, with absolute disbelief at Nord Anglia's explanation behind the expected full year profit shortfall.

From the FT: "The company blamed the profit shortfall on last June's acquisition of EW Fact ... it believed that the subsidiary's 1997 audited report and accounts, which showed pre-tax profits of £1.4m, were inaccurate. The actual figure should have been £80,000."

Aargh! £80,000! I instantly recognised the £80,000 figure mentioned in the FT. The amount had already been stated in Nord Anglia's accounts, produced six months earlier. The £80,000 figure was the revised profit of EW Fact after all the accounting adjustments!

I quickly got hold of the full announcement. I was amazed at this quote, highlighting the important word: "The Directors now believe the audited reports and accounts of EW Fact ... were materially overstated ... The Board's expectations for the acquired businesses in the current year were based on the audited figures."

I couldn't believe it. The Board knew about the overstatement when their full accounts were published in November 1998! It had already adjusted EW Fact's "audited" figures in black and white back then!

A prompt letter to Chairman Kevin McNeany was sent, questioning him about the announcement. The first reply stated that due to my name not being on the shareholder register, it would not be prudent for Nord Anglia to respond. Poor investor relations or what! It was only after I informed him of my nominee shareholder status, that Mr McNeany unconvincingly replied.

He admitted that the Board was already aware of the EW Fact's accounting adjustment. The profit shortfall was, he continued, "more than anything else" based upon a reduced student intake at an EW Fact school. That reduced intake was mentioned on page four of the "profit warning" release!

I sold at 153p, immediately after Mr McNeany's response. I was totally disillusioned with management's handling of the acquisition and subsequent warning. There was no point being invested in the company after losing faith with the management. But really, that was just the culmination.

I'd made an investment mistake. Clouded by the prospects of industry growth, I put to one side an average financial history. I put to one side the lack of a substantial operating track record. In summary, was Nord Anglia the proven and superior business operation I always try to look for? Not really, but it had huge prospects for growth...

I had read but ignored significant acquisition accounting adjustments. These adjustments, more than anything else, indicated all was not well at the EW Fact subsidiary.

A lesson learned. Don't get carried away with growth. Put simply, concentrate on the long term past record and look carefully at the company's operating record. If the company history isn't exceptional, why should the future be any different?

Finally, it could all have been a lot worse. I could have bought Nord Anglia on the tipsheet's recommendation, at far higher price!

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