Will shareholders sue Slater & Gordon?

After rising more than five-fold since early 2012, Slater & Gordon (ASX: SGH) shares have plunged by half recently, to $3.77 at the time of writing. The company has been hit by two controversies.

The first was the suspension from trading of Quindell plc (LSE:QPP) shares after the UK Financial Conduct Authority announced an investigation into statements made by Quindell in relation to its 2013 and 2014 accounts. SGH purchased the Professional Services Division (PSD) of Quindell last year but despite the structure of the acquisition minimising SGH’s liability, its shares fell anyway.

They fell further after SGH’s recent admission of accounting errors in its cash flow statement. This is much more serious for shareholders because as it goes to the heart of the listed law firm’s business model.

I won’t go into the accounting details as they’re both boring and arcane. Suffice to say the main issue is whether the company is as profitable from a cash flow perspective as it says it is. And if not, whether management’s highly acquisitive strategy in recent years has been covering up this deficiency.

The revelations undoubtedly raise significant doubts about the true level of cash SGH ultimately receives from customers. Its ASX announcement suggests cash receipts from customers have been overstated by around $92m over the past three and a half years.

SGH raised $890m at $6.37 per share in April to help pay for PSD. Fund managers that participated in the offer are understandably aggrieved at their subsequent losses. However, instead of reviewing their analysis to identify the errors they made, they’re directing their ire elsewhere: specifically, at the AFR for raising questions about the company and at hedge funds like VGI for having the temerity to back their bearish analysis by shorting SGH stock.

To me, this is the equivalent of the current Greek government being outraged that its creditors actually want their money back. I have little sympathy for them. There are a number of lessons investors can take from this saga.

Firstly, every investor (including me) makes mistakes. The subsequent and correct course of action is to learn from them, not blame others.

Second, understand that a stock doesn’t necessarily become a good investment just because its share price has fallen. A number of Intelligent Investor members contacted us after SGH’s share price decline suggesting it could now be good value. Whilst it’s true that investors should get more interested in a stock as it falls, that’s only the beginning of your analysis. Among other things, you also need to examine the business and its future prospects, management and insider ownership, its accounts and so on.

Which leads me to my final point: if one accounting irregularity is discovered, then there’s likely to be more. I’d be avoiding this company until management, the board and the auditors are replaced, the regulators have completed their investigation and the business appears to be once more on a strong footing.

Slater & Gordon specialises in suing others for their alleged misdeeds but in perhaps the ultimate irony, could now find itself on the receiving end via a class action on behalf of aggrieved shareholders. Surely the enterprising litigators at Maurice Blackburn are examining this, or is it professional courtesy not to turn on one’s own?