QUALIPORT
What Company Directors Don't Tell You

By Maynard Paton (TMFMayn)
June 5, 2003

"I want to emphasise to you that we do not face a financial crisis and that we have a clear and well thought out way forward"

So said Robin Jeffrey, chairman of British Energy (LSE: BGY), to institutional investors on August 14th last year.

Just three weeks later, the shares of British Energy were suspended. The accompanying statement read:

"British Energy announces that it has initiated discussions with the UK Government with a view to seeking immediate financial support and to enable a longer term restructuring to take place."

"The Board has reasonable grounds for believing that these discussions will be successful but there can be no certainty that this will preserve value for investors. The Board anticipates that if these discussions are not successful, the company may be unable to meet its financial obligations as they fall due and therefore the company may have to take appropriate insolvency proceedings."

Oh dear.

When evaluating a company, many investors place undue emphasis on comments made by directors. Unfortunately, such dependence is likely to lead to portfolio trouble. Managers of listed companies have a habit of being irrepressibly optimistic. Furthermore, what they don't say is often more valuable than what they do.

So it's no wonder to hear legendary investor Warren Buffet recently saying: "Almost everything we learn is from public documents.... We do not find it particularly helpful to talk to managements.... The numbers tell us a lot more than the managements. We don't give a hoot about anyone's projections. We don't want even want to hear about it."

As a rule then, long-term investors should concentrate first and foremost on the company's finances, competitive position and valuation. Facts about a firm's past are usually more helpful than opinions about its future.

With this in mind, it's worth revisiting the thoughts of five directors I've interviewed in the past. After speaking for at least an hour with each, my investment judgement on the companies in question took a notable turn for the worse.

Independent Insurance

During October 2000, I spoke to Michael Bright, chief executive of Independent Insurance. During the conversation, he said:

"Cash flow has been the single-most focused point within the company at any one time. Positive cash flow, as far as I'm concerned, is the lifeblood of what enables us to do what we do."

"We went back into positive cash flow in the latest first half... As we go into next year, we will be getting the payback for the big investment in systems. That, combined with what we expect to be very substantial growth next year, will put us back to the cash flow model that we have been used to in the past."

Eight months later, Independent's shares were suspended and the company eventually went bust. To put it mildly, the premiums from the policies Independent had been writing couldn't cater for the claims and liabilities that subsequently arose.

As this article showed, Independent's cash flow was very poor. It was certainly a sign of big trouble. But 'Brightie' said it wasn't a problem, didn't he? (Read more).

MMT Computing

During June 2000, I met up with Tony Grellier, the then managing director of IT consultancy MMT Computing (LSE: MMT). During the interview, I asked:

"I've calculated that the organic revenue growth rate between 1989 and 1999 was about 15%. Is that rate sustainable going forward?"

...to which Mr Grellier replied: "I believe it is sustainable."

Grellier also said: "We've had the experience of evolving over quite a long time and we've done well over the last year to move into the new [Internet] technologies. We'll get the benefits of that over the coming year."

"I think businesses are more aware of IT than they have ever been. First of all, the year 2000 problem has raised it to board level, and now of course the Internet has caused a different panic. Especially in the services end, with the development of the businesses processes to support Internet-based business, will come some pretty serious systems."

Less than a year later, Grellier quit MMT. As the IT industry deteriorated and MMT's revenues slumped, the move to supply Internet-based services became a rather costly error. (Read more).

No comment

There was no indication of forthcoming trouble from David Hearson of Latchways (LSE: LTC), Bill McIntosh of Trafficmaster (LSE: TFC) and David Page of PizzaExpress (LSE: PIZ) either.

In February 2000, David Hearson never told me mobile telecom firms would soon cut back on capital expenditure and with it, expenditure on safety systems for their 3G masts. Nor did he predict that a few of his North American customers would go bankrupt within two years. (Read more).

In September 2000, Bill McInstosh never whispered in my ear that his company's expansion into Europe would prove to be far too ambitious, that anticipated profits for 2001 would actually result in losses, and that telematic services would suffer a slower than expected take-up. (Read more).

In November 2000, David Page never told me competition would start eating away at his company's profits within two years. He never told me some of his older restaurants would need a costly refurbishment in 2003. And he never said he was planning to dabble with more embryonic restaurant formats either. (Read more).

Do your own research

After issuing profit warnings of varying severity, the table below shows how those five shares have subsequently performed:

Company                  Interview       Recent        Change
                        share price    share price

Independent Insurance       339p            0p          -100%     
MMT Computing               607p           97p           -84%
Latchways                   350p          222p           -37%
Trafficmaster               644p           26p           -96%
PizzaExpress                642p          384p           -60%

Unfortunately, after listening to what the directors had to say, I was upbeat on the prospects of all five companies...

So what can investors conclude from this, admittedly small, sample of directorspeak?

Well, either:

* Directors have difficulty envisaging bad times ahead, or;
* Directors can foresee trouble, but won't let on.

Whatever, the lesson for investors is clear: Do your own research. Company boardrooms will be the last to tell you bad news is on the way. Instead, significant director share sales, deteriorating cash flow and rivals hitting trouble may be forewarnings of danger ahead.

As mentioned earlier, long-term investors should concentrate first and foremost on the company's finances, competitive position and valuation. The stronger the finances, the fewer the rivals and the greater the margin of safety, the less there is to worry about directors optimistically talking up their company. At the end of the day, it's your opinion on where the company is going that counts.

The author owns shares in Latchways. A version of this article was first published in September 2002.