Introduction

Recently I received an email from a desperate retail investor raising serious questions about her investment in a well-known Caribbean fund manager. I know the feeling. The world is still trapped in an acute financial crisis which experts are only now beginning to understand and which is concentrating minds when it comes to where to invest your hard-earned money. One widely shared view, even by leading central bankers, is that the 2008/9 crisis was the worst since the 1930s depression. But there is a growing body of work that suggests that the 1980s recession was far worse as far as businesses were concerned than the 2008/9 crisis. It is a thesis that Professor Chris Higson and his colleagues at the London Business School are doing some empirical work on, and colleagues in the US are doing similar work and their conclusions will help us to see the bigger picture. The important question on the micro level is: how do companies respond to financial crises? What happens to their balance sheets and to profitability? Modern portfolio theory makes a number of assumptions, one of which is that investors are informed; that they are rational; and that they know what they want. We know that customers, including investors, quite often do not know much about the enterprises that they invest in; that they are not rational, often investing at the top of a bull market and sell at the bottom of a bear market. Few appreciate that equity investments are for the long haul, a minimum of five years. Obviously, this is not a Quick MBA in corporate finance, but just to give an idea of what is involved in retail investing and some precautionary steps to take.

The Environment:

Before looking at the firm you intend to invest in, have a deep look at the sector and how rival firms are performing. What are the long-term prospects? Where does the firm fit in the wider landscape? Is it growing, if so, is it organic or growth by acquisitions? Few firms separate organic growth from acquisitions in their financial reports. Then there is the inflation illusion: a firm that claims to be growing through sales must adjust for inflation, once this is done, quite often real sales growth is negative. In fact, even in good years, few firms have real growth. This flows in to what Joseph Schumpeter called ‘creative destruction’ – the death and birth of new firms.

Years ago we used to have tea and sugar plantations which were the top of the corporate tree, now they have been replaced by the big mining firms and the Apples and Microsofts of the new technology. When governments intervene to protect those old firms they often interrupt the natural rise of new industries and firms, preventing us from having had the new ones. You also need to look at operating leverage – the percentage of costs fixed in the short-term. The first impact of a recession is on revenue, the recession elasticity, forcing some firms to shift operating leverage to employees: to part-time work, redundancies, cuts in wages, etc. Workers take the hit, since labour is usually the largest cost. It is also important to watch out for the management of decline: selling assets to maintain cash flow since it takes two to three years for a firm to recover and return to pre-recession margins. Look also at the debt to equity ratio, for example; if during the recession sales fall by 15 per cent, for example, you want to know what is the full impact on the business and how long will it take before returning to long term equilibrium. Look at the firm’s earnings growth, its profit margins and its market share; you also want to know who the portfolio managers are, the equity analysts, how they get their research data, in-house or bought in and learn to build a model of the company’s valuation. Investment managers do not exist in a vacuum; they get their headwind from the macro-economy and in an economic climate of high unemployment, huge public sector debt, a massive current account deficit and political turmoil, the combination of those forces is a volatile investment environment. So you want to know what is the fund’s fixed income and property strategies, especially if it has bought properties as a medium to long-term investment?

Above all look at the management of the firm: who is the chairman and how long has he been in that position. Anyone occupying the chairmanship for more than three years should raise serious questions. Who is the CEO and is he related to the chairman? Who are the senior advisers, how were they appointed? Was it by open competition? Then look at the remuneration committee: who chairs it? How are the executives and independent advisers paid and how much? It should be written in to the articles of association that the chairman should occupy the seat for a maximum of three years, but certainly no more than five. Being chairman is not a lifetime appointment. The CEO and his senior executive should invest in any funds they manage, but in their own individual right., not under a corporate banner. If they have confidence in what they are doing this should not be a problem.

Basic Investing:

Once you have looked at the wider landscape, the basic rules of investing are simple: read up on your compound interest again, this is the key to investing. Then decide what you want to save/invest for and over what period and your risk tolerance – at the age of 21 your needs and risk tolerance will be far different than it would be at the age of 65. Once you have done this, you now have lifetime financial planning targets. You may not hit these targets every year, but they will remain useful guides. Before investing, make sure you do your homework: put some savings in a current bank account for a rainy day; that is money that is easily accessible if something goes wrong. In Britain, it is often suggested that you save in a current account enough to cover your living costs for three months if you were to lose your job or suffer injury; in Barbados it may be a bit longer. (There is also the matter of protection insurance, but that is for another time.) Apart from a mortgage, it is also important to reduce high-interest debt (credit cards, car loans, etc) to a minimum, before thinking about investing. Once you have done that, it is a better strategy to save small amounts regularly ie $50 a month than a lump sum $600 at the end of the year. This based on the dollar cost averaging, which gives an advantage in volatile market conditions, buying at low and high prices and balancing costs over a given period. Do not try to replicate the big guns: Warren Buffet, and the numerous Nobel Prize winners; nor should you try to be a mathematical wizard about asset allocation. Stick to basics.

Shadow Banks:

Apart from normal retail and manufacturing companies, Barbados, like most emerging markets, is locked in a scramble for so-called Shadow Banks, institutions that carry out a lot of the functions of a traditional bank, with the exception of accepting deposits. Shadow banks often lend money, trade in collective investments, securities, and other financial instruments, often without any regulatory supervision or audit. They may also be legally structured in many forms: merchant banks, investment banks, investment trusts (mutual funds), Trusts, private banks, wealth managers, etc – often without any close supervision or even a watchful eye from the authorities. Little is known by the public of what they do, and few questions are asked about their governance. They often run a number of collective closed ended and open ended investment vehicles. It is important to look carefully at what is under the managerial bonnet before buying their shares. Quite often what you see is not what you get.

Analysing a Company:

Financial analysis is the evaluation of a firm, using all available data, to examine its operating performance, including its profitability. This will determine how well the firm has used its assets, tangible and intangible, its human resource and its market share to provide a return on its investments. The firm should provide information on itself through its financial reports, including the annual report (all of which should be on its website), but a good analysts goes beyond this to look at extraneous information, the state of the market, key competitors, market share, going back over a period of time – three, five, ten years – to get a proper picture of the firm’s performance. Awareness of red flags is one of the skills that any good investor, analyst or regulator should have; any action out of the ordinary, however innocent, should be fully explained. These may include such things as late publication of the annual report, dedacting certain sections, the payment of annual bonuses to senior staff while declining to pay a dividend to shareholders, profits that outgrow cash flows generated from operations, and debt vanishing from the balance sheet. My favourite is an annual report stuffed with pictures of the firm’s community work, the chairman kissing babies and helping old ladies to cross the streets, of the cricket team playing against visiting Royalty – anything but financial details about the firm. It is usually a cover to hide bad news. If a firm’s board is incompetent or corrupt it can easily undermine shareholder value by building up debt then selling it off at a cheap price to vulture investors. Again, informed investors, alert financial analysts and journalists and well-trained regulators should be on the lookout for this sort of scam. Finally, if a fund manager, or any other business, who is a regular advertiser in a newspaper decides to withdraw advertising because of objections to the journalism, then that is clearly a matter for the regulatory authorities. Equally, it is a matter for the small investors in whose interests the media operate. Firms have a fiduciary duty to minority shareholders and, indeed, all stakeholders, failure of which is a dereliction of duty and a regulatory issue.

Charges:

The fund’s charges (what the firm charges investors), expressed as total expense ratio and annual management charges, should be explicit and on display on the fund’s website. This should include the domicile of the fund (because it operates from Barbados does not mean it is domicile in Barbados), the managers, researchers and analysts, the currency in which it trades, its share class (i.e. growth or income), its benchmark (ie interbank lending rate plus ten basis points, or the Barbados Stock Exchange and Trinidad Stock Exchange, or which ever is the higher, plus five basis points.)

Corporate Governance:

Corporate governance is especially important for Shadow banks. Their boards are often selected from a narrow pool, their executives can sometimes be members of that inner circle, and in the case of fund managers, their investment policies can be obfuscated and a bit of a mystery. In a poorly regulated jurisdiction, there often is no real demand for senior executives and advisers to be formally qualified, or at least have globally recognised qualifications. So, in some instances, an estate agent can be the property adviser but you want to know what qualifications and experience s/he has before allowing him/her to take control of your investments.

Investment Strategy:

Above all else, you want to know what is the firm’s investment strategy, one of the most transparent ways of understanding the inner workings of the firm’s management. The strategy should be based on risk and return for each of its funds, the higher the return sought the greater the risk. This must also be reflected in the overall asset allocation – for example, equities, fixed income and cash or near cash – and stock picking – i.e. which sectors and the individual firms. This entails more than just throwing a dart at a board; it involves the managers and analysts knowing the industry, going out and meeting the senior executives of the firms, rival firms and the shop floor workers. In short, decisions should be based on sound judgement and not just the prejudices of one or two influential individuals. If it is an investment fund, how is it managed, actively or passively? If they are passively managed, or simply mimicking a benchmark, then the annual management charge should be very reasonable. It is generally agreed that effective asset allocation and not stock picking that brings in the greater returns. So, choosing the right funds with the appropriate investment style is a better bet on a positive return than having a superstar fund manager. The bottom line is that the fund managers’ interests should be aligned with those of investors.

Analysis and Conclusion:

There is an old Barbadian saying that little children are fools, they have no right with sharp-edged tools. This applies more than anything to investments, in particular stock market trading and equity investments. Where stock market trades are complicated by company legislation which is out of date and not fit for purpose, it then becomes an open sesame for Ponzi schemes. Let me give an example: a company listed on the local stock exchange is, to all extents and purposes, owned by its shareholders. If company law allows a listed company to have A and B shares, with the owner of the A shares being the only people allowed to vote on the policy and governance of the firm while owners of B shares can only vote on restricted policies such as if it should continue to trade, then there is clearly a structural flaw. Further, if the non-voting B share owners do not to qualify as owners of the enterprise, but only as recipients of dividend payments, it becomes even clearer that the legal structure is not fit for purpose. Dividends are not guaranteed. If an ordinary retail investor has Bds$100 which s/he wants to save or invest. In a low interest economy, in which retail banks are paying interest rates below the rate of inflation, the investor will naturally be losing money in terms of purchasing power parity – that is, what a $100 can buy today, with inflation it will not be able to buy next year or the year after. So, rightly the investor looks at investing in the equity market with the expectation of getting a higher return. Although all investment is risk-taking, the normal expectation is that if the fund grows they will be entitled to an equal share of that growth; however, if the structure of the fund is such that ordinary investors are only eligible for dividends and there is no condition that dividends must be paid annually (or at agreed periods) then s/he must compare the dividends paid with any interest they would have attracted from the bank on their $100. Further, as already mentioned, it is important to note that there is no compulsion of the part of the board to pay out dividends; they may legally, if amorally, agree that instead of returning money to investors they would use that liquidity to make further purchases, in other words, use investors’ money to extend the capital structure of the fund (which, remember, is owned by a small clique of A shareholders). With a structure that stipulates only effectively non-voting shares are traded on the stock exchange, then the legal confusion that a listed company is owned by its shareholders is clearly wrong. In fact, most people who invest in stock market equities as individuals would be far better off – ethically and financially – to form an investment club and use that as the vehicle for their investments. They will save on exorbitant charges, own a proportionate share in the actual vehicle and will sleep better at night.