PORTFOLIO POINT: Investors can save themselves a lot of grief if they learn to read the signs of distress.
The collapse of Hastie Group entrapped some of Australia’s best investors and showed that the lessons of history have not always been passed down. There were some clear alerts in the Hastie situation that repeat previous collapses. Hastie is therefore a wake-up call that investors should apply in future situations.
Hastie was recommended by many brokers as an income stock. Here was a company that appeared to be well-managed and produced regular income with moderate profit growth. Perhaps the first early warning that there might be problems came when one of its rivals, Frigrite, got into serious trouble and later collapsed. The Hastie and Frigrite businesses were not the same, but Frigrite was an indicator that Hastie was operating in a very tight environment and that perhaps the income might not always be there. Then, suddenly, something strange happened to Hastie. Whenever you see a company acting in a way that is inconsistent with what you thought the group would do, it should always raise an alert.
In the case of Hastie, it began to undertake a series of rapid, small takeovers. Takeovers, whether small or large, are difficult exercises that will always test management if they are to be successful. Hastie took over many companies and, as we now know, never really integrated them; they were simply left to run their own race. This means the company did not have the management skills to take over so many groups. Shareholders will not know this without close questioning of directors.
The second alert comes when a company suddenly makes a major plunge overseas. I think overseas investment is something that Australian companies should do, but they have to take it easily and it is extremely dangerous if you also have a huge management challenge at home via takeovers. Hastie went headlong into the Middle Eastern construction boom in much the same way that Leighton did. Not unexpectedly, both ventures were disasters.
I think investors, when they see their companies go offshore, need to make sure that management is operating in a field that they know and is not taking too big a bite in the first instance. Offshore investment is difficult and needs to be learned, and the best way to learn is through a small bite. It is also extremely dangerous if the home base is not settled.
The third alert comes when you look at a company’s balance sheet and it has high debt and virtually no shareholders’ funds, if you eliminate goodwill. And that was the situation with Hastie; all the shareholders’ funds were in goodwill, and the company had high borrowings. In making any series of takeovers, almost certainly some will go bad. If they do and need to be written down, the writedowns may breach bank covenants that require a certain asset cover for loans. It is not easy for shareholders to understand the degree of vulnerability, but when you see all shareholders’ funds are goodwill and there have been a series of acquisitions, some of which have been funded by bank borrowing, it raises the warning signs. Banks want covenants so they can get out in times of danger. In the case of Hastie, the banks had not only loaned the company money, but had given performance guarantees. That would have been hard to pick up on a casual reading of the accounts, which is why the earlier alerts were so important.
In a crisis, the bank executives who arranged the loans are normally replaced by the tough money collectors in the banks. The continuity of relationships is often broken and the money collectors do not want to have egg on their faces, so are often tough even though it increases the level of bank loss. Certainly, that is the case in the Hastie situation.
Can auditors provide protection? They are supposed to, but always remember that auditors often delegate the auditing work to juniors and all too often audits in Australia rely on a detailed set of formal procedures, which look nice on paper but often miss the nub of the issue, as happened at Centro.
I am not sure what happened at Hastie but, leaving aside the company's issues, a few big damages bills will be very useful in returning senior auditors to doing what they are paid to do, rather than seeing auditing as a ticket to consultancy work.
I noticed that Hastie shares fell quite a lot in advance of the collapse. I am not accusing anyone of insider trading, but it is remarkable how the market knows. Very often, the knowledge comes from clients and suppliers, who suddenly find that payments are late or that the struggling company is not being organised correctly.
Figure 1. Hastie Group's steady demise
The investors who plunged money into Hastie late last year relied heavily on the abilities of former Leighton executive Bill Wild. I must confess that I also thought Wild might do a good job. But, in hindsight, the complexity that was represented in Hastie required skills that were rather different from those that Wild had. You almost needed to be like a receiver and shed what had to be shed, working closely with the bankers so that they believed that you were acting in their interests as much as you were acting in shareholders’ interests.
Wild might have made an excellent CEO of Hastie, had the company been just a bit better organised so that his talents could have been displayed.
One of the aspects of investing in companies that are struggling is the potential for very large retrenchment payouts. That entitlement is usually not on the balance sheet, and bankers sometimes don’t understand it until they are faced with the grim reality. This leads them to panic. So, if your company is struggling and has a large staff, be aware of the dangers.
Many of us are very reluctant to sell and crystallise a loss when a stock falls below what we purchased it for, but sometimes you have to take a deep breath and take the loss. Also, make sure you don’t look backwards, even though the company may recover. For every mistake you make on the upside, there will be two or three big downsides you will have avoided.