Postmortems & Premortems: what investors can learn from total losses

While it can feel a bit depressing to focus on adverse outcomes in these markets, I believe these are where the real investing lessons can be found. If we can learn from mistakes and challenging market conditions, we become better investors, and our future expected returns are much higher. So, continuing this theme, in this week’s article, I will relive a painful loss, examine a recent failure, and introduce the concept of a premortem, thinking about what might cause a company to die before it happens.

A Total Loss

One of the keys to successful long-term investing is to avoid severe adverse outcomes. It takes finding a 10-bagger to recover from a 90% loss but just a double to recover from a 50% loss. However, no such outcome is as severe as a total loss. This represents a permanent loss of capital. The reality is that there is a set of circumstances that will cause even the most apparently robust company to be a zero, and it often can happen overnight with no warning and no ability to exit a position. This is one of the reasons that investors should err on the side of greater diversification (a tendency to be overconfident is the other main one). However, the out-of-the-blue losses are infrequent. Often, there were signs that a business was close to failure. I have covered some of these topics in my recent articles (here and here) and in more detail in my book.

This focus on avoiding fads, frauds and failures means that I have had very few total losses in over 20 years of investing in UK small cap stocks. But I have had one: Redhall

Redhall was a specialist engineering business whose history can be traced back to 1932. In June 2019, they appointed administrators. They had recently had a profits warning and become loss-making. However, the balance sheet didn’t look terrible. Indeed, I invested after these warnings and initially did well from my investment as the market bounced back from an initial sell-off. We can’t see the historical StockReports for delisted companies, so I will have to turn directly to the last set of accounts to 30 September 2018. Although the company didn’t hold any cash at this date, the current ratio was 1.34. The current debt was a mere £209k. There was £5.24m of bank debt on top of this, but this was long-term in nature and shouldn’t have been an issue as the company said in January 2019 that:

Market conditions remain encouraging in the majority of the company’s core sectors and we see a strong pipeline of opportunities.

The vast majority of the assets were intangible and, in particular, acquired goodwill. The tangible book value was just £1.1m, but it was positive. And it seems these subsidiaries did have significant value because they were bought from the administrators. For example, Avingtrans (LON:AVG) bought Booth’s Industries. Many believe they got a good deal here as the company became highly profitable under new ownership.

The thing that appears to have caused Redhall to fail is working capital issues. In the announcement of their suspension from listing, the company said:

Further to the trading update released on 1 May 2019, Redhall announces that overall trading remains challenging and that the company’s short-term cash flows are under pressure, in particular, with regard to certain tax liabilities.

The fact that most of the receivables were contract assets and accruals was perhaps a warning sign. But this was not unusual for the company, and I missed this at the time. Regarding the mentioned tax liabilities, the company’s last period was loss-making, so the tax owed was primarily payroll taxes. At £1.2m on 30 September 2018, this was in the same ballpark as the £1.1m. So this shouldn’t have been a problem.

One reason I thought this company could survive these issues was that the listed Closed-End Fund Downing Strategic Micro-Cap Investment Trust (LON:DSM) had invested around 15% of their assets under management into RHL (at cost) and was known to support struggling portfolio companies with loans and equity raises. They had done this at both Fireangel Safety Technology (LON:FA.) And Real Good Food (LON:RGD) , both of which looked to be in a much worse state on the surface. Downing and Lombard Odier had already lent the company money as a shareholder loan in January 2019. It seems this was considered as in the same notice of suspension the company said:

The board of Redhall (the “Board”) has been in active discussions with certain of the company’s major shareholders and creditors to provide additional funding capacity to allow the company to alleviate the short-term cash flow pressure. However, it is now clear that there is no reasonable prospect that a viable solution for additional funding capacity can be found…

I have no idea why Downing Strategic Micro-Cap Investment Trust (LON:DSM) and other shareholders chose not to support the company further in this particular case. Clearly, they preferred taking a total loss on their equity and possibly their debt rather than risking further losses later by putting fresh capital in. This suggests that there were serious issues that were not publicly disclosed. However, we can’t rule out the working capital squeeze simply being too severe for them to fund.

Lessons from Redhall

So, what did I learn from this total loss:

• Not to rely on other shareholders to support a struggling company even if they have done so in the past.
• That published accounts are always historical. A company having a reasonable current ratio at a point in the past doesn’t mean it has one today.
• Every company can fail in unexpected ways. External shareholders rarely have the complete picture.

A Postmortem

At the start of this week, Safestyle UK (LON:SFE) announced that they had appointed administrators. This is a company that has been struggling for a while:

The initial problems in 2017 came from an aggressive new market entrant called Safeglaze. Due to these competitive pressures, Safestyle UK (LON:SFE) suffered from a series of profits warnings as the activities of this competitor intensified. In May 2018, they sued Safeglaze for what they claimed was “passing off, the misuse of confidential information, unlawful means conspiracy and malicious falsehood”. In September 2018, SafeGlaze agreed to change its trading name and rebrand fully within an agreed period.

FENSA, the industry regulator, publishes statistics on market share, which tend to be very accurate as every installation must be approved by building control or have a numbered FENSA certificate issued. Safestyle said that they were the number one supplier in 2022 and that even shortly before failure:

..the latest data from FENSA demonstrates that we are continuing to grow our market share, which is now estimated at over 8%.

This didn’t make any difference to the outcome, as their 27^th July Trading Statement revealed:

H1 industry data from Fensa shows that the market for installations is c.8% lower year on year, with Q2 representing a declining trend at c.12% lower. Alongside the reduction in installations in the market, the average number of frames per installation has also declined.

H1 order intake (value) was 6.4% lower than the prior year and our H1 order book closed 22% lower than an unusually strong H1 22 comparator.

This drop in demand accelerated the collapse:

With this trading statement, broker estimates for FY23 were updated to losses:

At the time, the company said that:

The net cash position at the end of the year is still expected to be positive. The Group also remains fully compliant with its borrowing facility arrangements and the full £7.5m facility continues to be accessible.

However, the current ratio revealed the perilous state of their finances:

[Note that the Stockopedia algos are a little confused by the year-end here. The latest published results are the 2022 figures, not the TTM figures, although this doesn’t materially change the figures.]

This isn’t a normal situation for the company either, as the increasingly negative working capital position reveals:

Although the company claimed they were going to be cash-positive at the year-end, the current net debt showed this to be a tall order:

This is despite raising money from the market in both 2021 and 2022:

On 19 September, the company issued a trading update describing a further weakness in industry demand and a considerable loss:

Consequently, the Board now expects the Group’s revenue for 2023 will be between £140m - £142m and consequently, underlying loss will be in the range of £(9.5)m - £(10.5)m.

The hope of net cash at year-end was also dashed on the rocks of reality:

On the above basis, year-end net debt is expected to be between £(5.5)m and £(6.5)m. The Group has debt facilities of £7.5m and was in a net cash position of £1.5m as at the end of its August reporting period. The trading outlook and timing of working capital outflows for the year to go are the primary cause of the expected year-end net debt position.

Blaming working capital flows seems odd, as these were already at historical lows. To me, the major issue appears to be their inability to cut costs rapidly enough to match demand, which is strange as commissions are a big part of their staff costs:

However, the significant costs appear to be on the manufacturing side, as the low and declining gross margin attests:

Whatever the true cause, it was now clear that the company needed fresh equity:

The Group intends to engage with stakeholders to strengthen the balance sheet in order to support its recovery and help facilitate future growth.

This appears not to have been forthcoming; hence, the company failed. I don’t think it helps that the company still traded at a premium to tangible book value despite precipitous falls in the share price. This meant that there was little in the way of hard assets to support the business as a going concern after netting off the liabilities:

Lessons from Safestyle UK (LON:SFE)

• Being a market leader and growing market share makes little difference to the outcome of a struggling business, especially in declining and fragmented markets.
• Beware of businesses that have large fixed costs; these are unable to act as quickly to cut costs. This can appear as a big increase in admin costs as a percentage of sales or a decrease in gross margin.
• Trust those warning signals of a declining current ratio, increasing debt and ballooning negative working capital, and don’t trust management’s commentary that says everything is okay.

The Planning Fallacy and Premortems

One of the challenges investors face is that they tend to be too optimistic about the companies they research. The tendency to assume the best outcome when faced with a range of possibilities is known as ‘The Planning Fallacy’. Amos Tversky & Daniel Kahneman came up with the name in 1979 as part of their Nobel Prize-winning work categorising behavioural biases. But the idea has been around a lot longer than that. The Planning Fallacy is why DIY projects always take twice as long to complete as expected. This is why almost every corporate IT project costs much more than the initial estimate and delivers fewer benefits. It seems particularly prevalent in the most complex projects, like large government contracts; HS2, anyone?

The Planning Fallacy is a form of optimism bias – the tendency for people to underestimate the likelihood of something bad happening. Generally, having an optimistic outlook on life is a good thing. Optimists are, on average, healthier, more attractive, successful, and resilient. But when it comes to investing, the tendency to look on the bright side of life means that investors can fail to spot serious issues with a company.

One method that project planners have come up with in an attempt to overcome the planning fallacy is called conducting a premortem. Instead of hypothesising why a project might fail, the planner starts with the assumption that the patient is dead and works backwards to find out why.

This same form of thinking can be applied to investment ideas. Imagine your largest holding or your latest purchase has just appointed administrators. After overcoming the initial shock, think about why this may be. Perhaps they couldn’t pay a debt when due or a supplier. Perhaps they had a legal judgment against them or a warranty issue. Perhaps there was a series of fraudulent transactions. For each scenario, consider how this might happen and what the early warning signs were. A premortem will highlight the things to look out for. It will show the most significant risks and how they should be mitigated. It will provide essential questions for management calls (and potential red flags if management refuses to answer them.) Most importantly, a well-conducted premortem may mean that an investor avoids having to do a postmortem on a portfolio constituent in the future.