The UK Financial Conduct Authority’s inquiry into the supermarket Tesco is almost certain to miss a key part of the story – how investors enabled this dysfunctional culture. In September the retailer announced it had significantly overstated its first-half profit forecast.
One veteran financial commentator, Anthony Hilton, has made a powerful case that Tesco is yet another ‘preventable surprise’. But reading what most investors now say, you would think that the issue both is new and rare. Sadly, the facts do not support this narrative, which combines two excuses – a ‘bolt from the blue’ and ‘bad apples’ – that the City loves.
A Citi research note in 2010 was critical of Tesco’s accounting culture. Such notes from bulge-bracket firms are very rare. Moreover, Tesco’s ranking by GMI (now part of MSCI) had been declining over the last 15 months. In addition to the total compensation ratio of the CEO relative to the CFO, the trend in accounts receivable to sales ratio is a potential warning of accounting irregularities. Tesco had a high and accelerating ratio while the industry benchmark was largely unchanged.
ESG assessments can often be lead indicators of hidden cultural trends. The good news is that some analysts and investors did make the right call. In October 2013, Cantor published a research note, ‘It’s just an illusion’, and returned to this topic in November 2013 with a further comment entitled ‘A desperate move?’.
Fund manager Terry Smith has also documented how even basic analysis should have made investors much more concerned. He highlights how over 14 of the past 18 years (back to 1997 when Sir Terry Leahy became CEO) Tesco’s free cash flow less its dividend (with free cash defined as operating cash flow less gross capital expenditure) was a negative number. Even Sir Terry’s predecessor (and mentor) has raised concerns in a very public manner.
Put simply, what happened at Tesco should not be ‘news’ to any half-decently informed sector analyst.
More generally, investors seem shocked that accounts are not accurate representations of the financial health of a company. Where have these good folk been? Economists at Duke University showed in 2006 that CFOs will trade off practically everything – even if they know these investments will result in higher profits – simply to protect ‘the number’. They also documented in 2013 that CFOs themselves believe that 20% of all earnings announcements are intentionally misrepresented. The average misrepresentation is large, 10% of the announced value, with 60% managing up but 40% intentionally low-balling.
So did investors insist on a new auditor for Tesco to replace PwC? At 30 years, this is the fourth-longest auditor relationship among FTSE100 companies. And did they vote against a chairman who had been a direct report of the CEO?
Because investors do not learn – and do not act – ‘preventable surprises’ keep happening – BP, Japan’s Tepco, the list goes on. Most people in the investment system are clever and decent, so what causes this?
Sadly, detailed diagnoses about how complex systems go wrong do not often result in turning things around. The usual tool-kit – research, inquiries and litigation – delivers corporate apologies, some heads and new codes but these clearly do not work
So what might have value? Let us create a small community of investment and related professionals who genuinely care about what has gone wrong and who learn by doing – who take actions even if the steps seem really small and who then reflect and share the learning.
If anyone – me included – knew how to get others to do what is needed, we would not keep having these wake-up calls.
Raj Thamotheram is CEO of Preventable Surprises and a Visiting Fellow at the Smith School, Oxford Universit