Scottish fund manager Colin McLean believes that investors of all types are routinely taken in by an over-reliance on published corporate information.

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With his actuarial training and the nose for a bargain that is native to a certain breed of his countrymen, the Scottish fund manager Colin McLean has long held the view that investors of all types, professionals included, are routinely taken in by an over-reliance on published corporate information. At a recent seminar in London, he expounded on his argument that the markets often fall a long way short of perfection in their use of information.

The credit crisis, he pointed out, has provided a wealth of interesting and topical case studies. The share price of Northern Rock, for example, began to fall well before awareness of its problems were formally notified to the Bank of England in August 2007, at least if you believe the testimony that was presented by the FSA, The Bank and other witnesses at the Treasury Select Committee hearings into the Northern Rock collapse.

In fact, the share price chart clearly warned of the shape of things to come as early as May 2007, which was when the 50 day moving average fell below the 200 day moving average, an important technical signal implying that the first knowledgeable selling of the shares may have begun even earlier, at a time when the regulators were still happily dismissing the warning signs of stress at Northern Rock as “just a blip”.

Stock analysts meanwhile were still apparently being lazily blindsided by the misleading signals coming out of the board of the bank. These included share buying by the directors themselves (although it was small relative to their overall wealth and earnings), the remarkable 30% proposed increase in the dividend and the suspiciously smooth historic record of steadily rising reported profits and earnings per share. 

One analyst was still describing Northern Rock shares as “still a fantastic long term story” in April 2007, a month after the bank had first breached its capital requirements and was heading towards its eventual collapse and rescue. It was also of course around this time that two hedge funds took big stakes in the stricken bank, inviting themselves to an expensive party that continues to cloud their hitherto impressive reputations and performance records.

Dividends and earnings per share, concludes Mr McLean, “beguile many supposedly sophisticated investors, particularly those focused on superficial value”. Nevertheless the reality of the situation at Northern Rock was already being recognised by the crowd, as measured by the share price. To the extent that the board and FSA were aware of the problem, Mr McLean’s argument is that those who did know that things were deteriorating fast clearly lacked any incentive to make what they knew available.

Indeed the actions of the board over the dividend, for example, clearly pointed in an entirely opposite direction. Yet throughout 2007, adds Mr McLean, there was information available from other sources for those who cared to do some digging – into the filings of Northern Rock, for example, or into the obscurer corners of the IVA (Individual Voluntary Arrangement) market, where one bank – Northern Rock, as it turned out – was rejecting a higher proportion of IVAs than any of its competitors, apparently in order to avoid impairment of its reported assets as a result of bankruptcies.

The warning signs, in other words, were there for those who had the time to look and this “submerged information” did indeed gradually seep into the market.  One potentially troubling conclusion for many investors, Mr McLean goes on to suggest, is that in times of acute market stress at least, technical analysis might in fact offer just as many valuable clues to investors as fundamental analysis based on the information provided by companies.

It is not news, of course, that companies routinely try to prevent a rosy picture of their progress as a company. But is the problem getting worse? Mr McLean highlights the case of GlaxoSmithKline, the UK’s fifth largest listed company whose shares have been dismal performers over the eight years since the current but soon-to-depart chief executive was first appointed a director. In that time the shares are down more than 40%, in a period when the market itself has been broadly flat, and the total shareholder return, including dividends, has been negative.

Yet you would not get that impression from a casual read of its 180-page annual report, or indeed from the “adjusted” earnings per share that the company itself promotes as its record of achievement. According to Mr McLean, there have been six significant positive adjustments to reported earnings per share at Glaxo in the last ten years and the term “adjust” or “adjustments” occurs on average more than 100 times in each set of the company’s report and accounts. 

In 2007 the effect was turn what would have been conventionally a 1% fall in earnings per share into a positive 10% gain. Senior management’s incentive arrangements appear to encourage the company to carry on adjusting, just as they may have been a factor in the bizarre and misleading dividend and earnings announcements of banks in the run up to the worst banking crisis for many years. All investors eventually reap the rewards of this collective myopia which, in Mr McLean’s words, leaves investors having to recognise that in today’s world of turbulence and perverse incentives “earnings per share and dividend yield are amongst the least useful investment metrics”, instead of the central pillars in analysis that by rights (and in theory) they should be. This conclusion is hard to gainsay.





Jonathan Davis
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