Terry Smith Straight Talking

The Lex Column: Mr Blobby’s returns

Appeared in The Financial Times on 16 July 1996

Few authors have popularised the arcane world of accounting as successful as Mr Terry Smith, UBS’s former head of research. Back in 1992, his notorious “blob guide” identified a dozen ruses used to inflate reported profits and named the companies which employed them most. Four years on, as the second edition of Mr Smith’s Accounting for Growth is about to be published, the state of British accounting is much improved: the Accounting Standards Board has closed, or is in the process of closing, most of the loopholes Mr Smith highlighted.

But what about the companies that figured prominently in Mr Smith’s blob guide? Some, like Grand Metropolitan and Trafalgar House, have been disappointing investments. But others, like British Aerospace and Granada, have been phenomenal successes. Indeed, anybody who bought shares in just those companies which used seven or more of the ruses Mr Smith identified would have done rather well. Since the book was published, such a portfolio would have risen 116 per cent –outperforming the market by 30 per cent.

The blob guide was, of course, never intended as a simple method for picking stocks. It was designed to make investors think by sowing scepticism about the figures companies report. Mr Smith especially wanted to wean shareholders from their fixation on earnings per share as the only measure of corporate success and look at yardsticks like cash flow and return on investment as well. Despite everything the ASB has done in recent years, Mr Smith’s broader purpose remains as valid today as ever.

© The Financial Times Limited. All rights reserved.

Enlisting mother to figure it out - Interview - Terry Smith

Robert Bruce finds Terry Smith unrepentant in his updated Accounting for Growth

Appeared in The Times on 15 July 1996 

When a book on company accounts sells 80,000 copies you know that something is up. Terry Smith, who was sacked as head of UK company research at UBS Securities in 1992 when the first edition of his book, Accounting For Growth, appeared, has now produced an updated second edition. And he is gloriously unrepentant about the furore the book created. "Telling a publisher not to publish because there was a row brewing was a bit like giving someone a tanker full of petrol with which to extinguish a fire," he says in the introduction to the new edition.

The row then was about the infamous "blobs". Smith created a Major Companies Health Check table listing 12 creative accounting techniques and showing which major companies used which. This was why British Airways and Grand Metropolitan, under the then Sir Allen Sheppard, brought pressure to bear on UBS. GrandMet had won the unfortunate accolade of being the Top 200 company awarded the most blobs.

"It is a supreme irony", says Smith in the new book, "that after the first edition was published and I was fired and sued, I had to check the accuracy of a number of entries, including GrandMet's, and found that I had missed one: GrandMet was using ten techniques."

This time around the "blob" guide has been dropped. Smith feels that it diverted people's attention from the real issues. "You couldn't quantify the extent of a `blob'," he says. "They were being used as a sort of `magic bullet' solution and magic bullet solutions have no value."

For Smith the real issues are the analysis of accounts and the ability of users to spot when companies are being economical with the truth. "The users are the biggest problem," he says. "If people are silly enough to disregard the figures then they are still going to come a cropper, regardless of whatever rules and regulations are in force."

In the book he uses BTR as an example and its use of acquisition accounting after it bought Hawker Siddeley in 1990. "In 1992, BTR had used provisions of £305m (not all of which were for Hawker Siddeley) in reporting pre-tax profits of £1,085m," Smith points out. "Think about that. One third of reported profits were there only because BTR had provisions with which to cover costs. In the first half of 1993, a further £81m were utilised, of which £47m were for Hawker Siddeley, in reaching profits of £602m. This left £93m of Hawker Siddeley provisions outstanding.

"It did not require a brain the size of a planet to work out that the Hawker Siddeley provisions would be exhausted in 1994, and that then BTR might struggle to maintain its profitability."

Smith raised these issues at meetings of institutional investors. But the response he received only confirmed his view that the problem is as much with the analysts as with the accounts. "You didn't need to do a great deal of analysis," he says, "and it certainly wasn't rocket science." He cites one example where the analysts' questions homed in on the use of a new BTR product at Denver Airport. "That," says Smith, "is trainspotting, not analysis."

In his book he concludes that "the problem is not whether it is truly possible to spot creative accountancy, or whether financial weakness and failure can be detected by a systematic approach. The problem lies not in devising this analysis but rather in the human inability to accept objectivity."

Smith felt the BTR experience was "a very instructive episode". In the book he recalls how "when I was touring institutional investors to talk about BTR one of the retorts I frequently received was `Ah, but BTR generates cash'. This statement in itself is almost meaningless." He goes on: "How much cash was BTR producing? The same as its profits (taken at an equivalent point in the cashflow statement and profit and loss account: it is no use comparing operating cashflow with retained profits), or more or less? What return on capital did the cashflow represent? Were the cashflows generated by repeatable items such as operating profits, or was the company squeezing working capital, or making disposals for cash which could not be repeated?"

Smith is fond of testing the figures against "what my mother would have thought the company meant". On that basis "of course BTR were generating cash, but was it the right amount?". His lambasting of the analysts has a serious underlying point. "People", he says, "lose sight of what the Stock Exchange is for. It is a method of allocating capital. Good companies should go up in share price and the cost to them of capital should drop. Bad companies should suffer a fall in share price and their cost of capital should rise. It is a serious point. The system should ensure that bad companies are starved of capital and cannot do any more damage to the economy. The capital should go to good companies which are creating wealth."

This is where the analysts come in. "In a social sense", says Smith, "the analysts should work as a conduit."

From his experience Smith thinks analysts are poor at their work and as a result companies that are disguising their performance get away with it and suck in capital that ought to be placed elsewhere in the market.

"People", says Smith, "have to relearn the story of the Emperor's new clothes. Otherwise we might just as well have a company statement saying `we have had a jolly good year' and leave it at that."

Smith goes on: "The problem is that we have bred the wrong culture of analysts. They tend to be people with industry experience rather than people who understand accounts. And analysts are all terribly polite and put up with all the strange wooliness. In the US they are much ruder and blunter."

The four years since Smith's first book has seen the rise of the Accounting Standards Board under the chairmanship of Sir David Tweedie, and a wholesale shakeout of the rules that govern financial reporting.

Smith is impressed. "The foundation of the Bureau was a recognition that there was a great deal wrong with UK accounting," he says. "Tweedie has set about correcting this with an almost evangelical zeal."

But he also recognises that "whatever rules you put in place, smart people will find a way to express a distorted and flattering picture of their performance".

And he is worried that we are at a point in the economic cycle where good news is preferred to bad. "In the third or fourth year of a recovery people's desire to hear about reform wanes. The balance of power between the gamekeepers and the poachers has swung back to the corporate sector and the momentum of reform is slackening."

But Smith's conclusions remain the same: "The investor must perform his own analysis," he says. They should ask questions. They should be objective. And they should wonder what their mothers would think of the meaning behind specific company policies.

But "if the answer is not satisfactory in terms of allaying the investor's concern that creative accounting is in use then the best solution is not to invest", he concludes.

Accounting for Growth, by Terry Smith, is published by Century at £14.99.

© The Times

Playing with numbers - Business Focus

By Terry Smith
Appeared in The Sunday Times on 14 July 1996

Accounting for Growth was "the book they tried to ban". I was UBS's head of research and was sued because of the revelations. But the book became a No1 bestseller as investors clamoured to read my guide to the accounting tricks used by corporate Britain, some of which had decimated share portfolios during the recession.

There were complaints before publication. The first came from Tiphook, whose chairman, Robert Montague (subsequently declared bankrupt), asked UBS to have his container-leasing company dropped from the book. But Montague did not have enough clout to cause a problem.

This came when Grand Metropolitan discovered that it had the largest number of mentions in my Accounting Health Check table (it became known as the "blob guide" because each piece of creative accounting earned a blob).

Lord Sheppard, GrandMet's chairman, did not like this and pressure was brought to bear. When this did not work, Sir Colin Marshall, a GrandMet non-executive director and at that time chief executive of British Airways, a UBS corporate-finance client, also intervened.

UBS told me to halt publication and when I refused I was suspended, then fired and sued. The rest, as they say, is history, so why repeat these old war stories? There are three reasons. One is that investors who think they are smart enough to spot all the conflicts of interest that may work against them in the post-Big Bang City are mistaken, as my experience showed. The second is that my analysis was proved broadly accurate as the recession developed. The highest-scoring companies in the blob guide were (in descending order of blobs) GrandMet, Ladbroke, Trafalgar House, Albert Fisher, British Aerospace, Ratners, Queens Moat Houses, Lonrho and Tiphook. All subsequently underperformed or worse. The real disasters were Queens Moat, Ratners and Tiphook, where investors lost most of their money. But even the mighty GrandMet sharply underperformed the market over the next couple of years.

Third, what else can we learn from this episode? If I ran a company and an analyst decided to criticise my accounts, I would not attack him in public or call his boss and demand a retraction, or his dismissal. Rather, I would smile knowingly and hope the poor misguided fellow drove the share price down so I could buy a few more shares.

In my experience, when companies start issuing threats and bringing pressure to bear to stop criticism, this is a better indicator that something is wrong than all of the "blob guides", accounting books, analysts' circulars and charts put together. As the saying goes, "hollow vessels make the greatest sound". BUT can investors spot problems before a chairman starts threatening an analyst?

In the latest edition of my book, I have avoided the blob guide. Concentrating alone on any single number such as earnings per share or even my own blob guide is dangerous. Here instead are some investment survival techniques, while below I highlight companies that have used questionable accounting techniques.

There has been a resurgence of the takeover boom in the 1990s and I believe takeovers and disposals are the main driving forces behind creative accounting. For this reason the companies highlighted have all been chosen at least partly for their takeover activity. Although takeovers tend to lead to a honeymoon period when the market is entranced by apparent earnings growth, in reality they rarely enhance shareholder value.

Successful investment is a filtering process: companies have to pass through various filters to be eligible for investment. Several successful investors seem to use such an approach. Jim Slater uses "sieves" such as a low price/ earnings multiple when compared with the growth rate. Filters such as this or good cashflow per share are useful in whittling the universe of shares down to a few. They are worth studying further. Once you have identified a stock as interesting, there are some tests you can apply to see whether there are telltale signs of creative accounting.

Read the accounts thoroughly, including the notes. I am talking about the profit and loss account, balance sheet and cashflow, not the chairman's blurb. Hence the suggestion: read the accounts backwards. When did you last read a chairman's statement saying: "We have made a hash of running the company and you should not invest in it". So why are you bothering to read it first?

You are unlikely to learn much from simply reading the accounting statements. Calculate the numbers as you go along as follows:

What is the operating margin (operating profit divided by sales) and how does this compare with rival companies and previous years for the same company. If the margins are apparently much better than the competition there should be a good reason.

Remember Wickes, Spring Ram and BM Group, where apparently superior margins were in fact the result of creative accounting or worse, and investors lost their shirts as a result. By contrast, Coca-Cola's superior margins are the result of powerful branding and competing in a virtual duopoly with Pepsi.

Cashflow is another key number. How does operating cashflow compare with operating profit? Is it larger (good) or smaller (bad) and does cashflow consistently outstrip profits or vice versa. How does the cashflow look after deducting capital spending, and how does this "free cashflow" compare with earnings per share? Remember, cash is king. It is much harder to "create" cashflow than profits, and cash is a fact whereas profits are a matter of opinion.

Calculate the returns the company is generating, as you would for any other form of investment such as a building-society deposit. Divide pre-interest or operating profit by total debt and equity capital to get Return on Capital Employed (ROCE). Remember to include goodwill written off, as excluding it can give a false impression of returns.

How does this return compare with yardsticks such as the long gilt yield, a risk-free return, and how has it been moving in recent years? A company would need to be growing strongly for you to accept a current return lower than the gilt yield. Also examine the returns using operating and free cashflow. If these are much lower than the profit returns, be suspicious. If they are higher, so much the better.

Read the accounting policies in the notes. Do any give cause for concern, such as expenses being capitalised? If so recalculate how profits would look with these expenses in the profit and loss account. Have any changed since last year? If so why and what is the effect of the change on profits and cashflows?

Calculate the depreciation charge as a percentage of fixed assets. Over how many years are the assets being written off, and does this seem sensible given their nature? Has the percentage written off changed from last year, and if so are assets being written off more or less quickly?

BTR's depreciation charge changed after its Hawker Siddeley takeover from 10% of assets to less than 7%. This has effectively boosted 1995 profits by about £160m and it is low relative to peer group companies such as Hanson, Tomkins and Williams.

If a depreciation charge is abnormally low it may have to be corrected, leading to lower reported profits. If it is not corrected, cashflows will continually undershoot profits because the capital spending to maintain fixed assets will continually exceed depreciation, a situation in which BTR finds itself.

Look at the tax charge on the published accounts, not least because the Inland Revenue has far more information about a company's activities than you have from the accounts.

If a company's tax charge is below the corporation tax rate, ask why. There may be a straightforward explanation, such as tax losses brought forward or operations in a low-tax country such as Hong Kong. But, generally, if the tax charge is subnormal, it indicates that the Revenue does not regard a portion of profits as taxable.

Avoiding low tax-charge companies in the 1980s would have enabled investors to miss out on some big losers. They included Polly Peck, Queens Moat and Costain.

Last, look at interest paid or received. Is this a reasonable percentage of average cash or debt in the opening and closing balance sheets?

AN APPARENTLY high return on cash or low cost of debt may indicate that the company is subject to seasonal cashflows, or has made large acquisitions or disposals during the year. But it may also indicate that the company is window dressing its balance sheet to make the debt look low. Remember, a balance sheet is only a snapshot of a company's finances on a particular day, and companies usually choose as their year end a time that paints the best picture. For retailers, Christmas takings appear on the December 31 balance sheet.

An apparently high return or low debt cost may also show that a company is mismatching currency assets and borrowings to bolster profits by taking advantage of differential interest rates between currencies.

Sometimes if the income from this mismatching is routed through an offshore tax haven, you can pick it up from either the apparently low interest charge for the size of the group's borrowings or the low tax charge. Hanson, which has substantially underperformed in recent years, has had a tax charge over the past 12 years ranging from 15.3% to 28.9%. 

Accounting for Growth by Terry Smith is published by Random House at £14.99

© The Sunday Times

Mr Blob is back with a vengeance

By Nils Pratley
Appeared in the Daily Telegraph on 13 July 1996

Terry Smith caused a furore with his first attack on City accountants. Nils Pratley sets the scene for his second salvo.

TERRY SMITH, a leading City scribbler who provoked one of the most entertaining City rows for years with his book exposing suspect accounting methods, is back with part two. Last time, his unashamed attacks on the profits massaging he alleges was executed by some of Britain’s largest companies lost him his job.It caused acute embarrassment to Swiss investment bank UBS, where he was head of research, and lasting damage to the share price of Grand Metropolitan, the Smirnoff vodka and Ha¨ agen-Dazs ice cream giant which came bottom of the class. Accounting for Growth, mark two, is out on Monday and the targets are as big as ever. BTR, the conglomerate whose shares have fallen 27pc this year, is the company that receives most flak this time. Smith, 43, is a pure outsider who, according to his critics, attracts trouble. Before his first book, Accounting for Growth, he was best known in the City for allegedly punching a fund manager at a black-tie dinner and, as the analyst at stockbroker BZW, for advising clients to sell shares in its parent company, Barclays Bank. Smith, who talks precisely and quickly, replies ‘‘no, no and no’’ to allegations that he is ‘‘proud, arrogant and abrasive’’. But he adds: ‘‘It is a difficult job unless you have some kind of ego because you have to think you are right and others are wrong.’’ He is an unlikely hero of the accountancy world. His father was a lorry driver who contracted asbestosis after a brief spell working in an asbestos factory. His mother, he says, ‘‘cooked my dad’s dinner’’. It was an East End upbringing. George and Billy Walker were friends of the family and lived around the corner. These days he has a flat inWapping and has just bought a Georgian rectory in Essex with his wife Barbara; they have two daughters. He drives a Porsche 911 Carrera and also owns an AC Cobra, a fast 1960s sports car. He also keeps a horse, which he rides in one-day events and cross-country trials, and has a yacht moored in Cork in Ireland. He gained a first class degree in history at Cardiff University but turned down the offer of a lectureship to make some serious money instead. He joined Barclays, where he managed the Pall Mall branch before being dispatched to the finance department. There, he came into contact with stockbroking analysts and eventually joined their ranks. Between 1984 and 1989, he reigned supreme as the number one rated banking analyst and was an obvious candidate when UBS was hunting for a £300,000-ayear head of research. It was all achieved without training in formal accountancy, apart from an MBA course. ‘‘I think, in terms of analysing things, it may be a bit of handicap to be an accountant,’’ he says. ‘‘If you have enough aptitude to work out the numbers and what they mean without being an accountant you probably have an advantage because you are not in a straight - jacketed way of thinking.’’

Accounting for Growth started life as his first major research for UBS. The recession was looming and Smith sensed that accounting would become a hot subject. He suspected that much of the increase in corporate profitability in the 1980s was the result of accounting sleight of hand rather than genuine growth. Polly Peck and British & Commonwealth had gone to the wall, despite reporting profits until the last. How could it happen? One of Smith’s maxims was an old one — cash is king. ‘‘Profits are someone’s opinion (or true and fair view) whereas cash is a fact,’’ he wrote, after identifying 12 accounting techniques, all of them legal, that tended to flatter profits. The eye-catching element of research was the ‘‘major companies accounting health check’’, better known as the ‘ ‘blob guide’’. Here, Smith placed a blob

against the name of each company for each questionable technique it used. Institutional investors loved it and for two consecutive years voted it the best research they had seen. Douglas Ferrans, chief executive of Scottish Amicable Investment Managers, is a longstanding fan. ‘‘Terry won’t take anything at face value,’’ he says.

‘‘He is hyper-critical of any number that is presented to him by a company, particularly in a report and accounts. Others are now doing the same thing but Terry was genuinely ahead of his time and has done a lot of good.’’ But even some of his greatest admirers in the City say he can be prickly. Neil Tyson, fund manager at Prolific, says, half in jest:

‘‘I think it’s the Napoleon complex with being so small [Smith is about 5ft 7in tall]. He comes across as a bit arrogant but you just have to give as good as you get with him. Everything is either right or wrong and there is never any grey area with Terry. Professionally, I find him very useful.’’ David Poutney, banking analyst at Panmure Gordon and a friend and colleage for over 20 years, says: ‘‘What he does have is a very cutting wit. He definitely does not suffer fools gladly and he can be very aggressive.’’ The drama began when Smith was invited by publisher Random House to turn the Accounting for Growth research into a book. Tiphook, the container rentals group, knew it would be featured and wanted to know what was being said. So, too, did Grand Met, which discovered from early press reports that it had scored the most blobs. Sir Allen Sheppard,Grand Met’s chairman, inquired. Then, Sir Colin Marshall, British Airways chairman and a Grand Met non-exectuive director, did the same. UBS and Smith rowed internally for while, with the bank arguing that in-house rules laid down that research should be shown to companies in advance and Smith saying there was no such guideline and that the book was now in the hands of Random House. UBS then sued the publisher and first suspended, then fired, Smith. Smith counter-sued and the actions were settled out of court only 18 months later. The episode touched raw nerves. UBS vigorously defended itself against the charge that it was appeasing angry clients; Smith denied he had engineered the dispute; Ernst & Young waded into the argument , denouncing the book as ‘‘dangerous and irresponsible’’. Even to this day, the details of who said what are being cleared up. In March this year, within a week of retiring from Grand Met, Sir Allen, now Lord Sheppard, fixed a meeting with Smith. ‘‘All I wanted him to know was, just for the record, that I didn’t try to get him sacked,’’ says Lord Sheppard. ‘‘I also congratulated him on the fact that, although he didn’t do our share price any good, he had handled the whole thing quite skilfully in terms of public relations.’’ For Smith, the moral is clear. ‘‘I feel vindicated on a number of counts,’’ he says. ‘‘The two companies that complained were Tiphook and Grand Met. Tiphook has, for all practicable purposes, gone bust and Grand Met has underperformed the market by a huge amount, which is not a bad record.’’ Smith’s personal earnings, meanwhile, have outperformed. Thanks to the row, the book sold an astonishing 55,000 copies. He is now a partner at Collins Stewart, a boutique stockbroking house, and says he makes more than he ever did at UBS. As a sideline, he has even tried his own hand at business, becoming an Athena franchisee. ‘‘I had the only franchise agreement that had a put option to sell the thing back to Pentos [the parent company],’’ he says. His timing was impeccable. He exercised the option in November 1994; by New Year, the receivers were in at Pentos. He manages all his own money, showing a bias for small companies.

At the moment he is ‘‘pretty liquid’’ but has investments in Azlan, Business Post, Quadramatic, and Rutland Trust. Amid all the fuss, it is easy to overlook the fact that one of the main aims of the books is to help investors, large and small. For both, he has a message: ‘‘You can’t get some guy to write you a guide for £14.99 that will make you a fortune. You have to read the guide, and an awful lot besides, and then do a lot of hard work. It is sad but true.’’

© Telegraph Media Group Limited 1996