TheChek News Flow

Study shows that when auditors are fired late in the year, accounting problems are more likely

When a company and its auditor split up, it can be a sign of trouble in the books. But the two sides typically don’t give a reason for the breakup.

Two accounting professors instead looked at the timing of the split. They found that the later in the year it occurs, the more worried investors should be.

Most auditor changes happen early in the financial year, generally in the 30 days after the filing of the annual report. That is when companies typically choose their auditor for the new financial year. After that 30-day window, however, the chances of future accounting problems start to increase, according to the research.

When one of the biggest owners of radio stations in the U.S. fired its auditor in June 2019, it said there had been no disagreements over accounting issues.

A year later, Townsquare Media Inc. disclosed accounting errors dating back to 2017 and restated its financial statements. The company’s 2018 net loss tripled to $97 million. Its stock fell 16% that day.

The errors occurred while the Purchase, N.Y.-based company was being audited by midsize accounting firm RSM US LLP. The problems occurred in areas including the impairment of broadcasting licenses and the treatment of deferred tax losses where judgment by managers and auditors often comes into play.

A spokeswoman for Townsquare said the restatements were limited to noncash intangible assets and didn’t affect previously reported revenue or earnings before interest, taxes, depreciation and amortization. A spokeswoman for RSM US declined to comment.

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Analysts and investors find opportunities in companies more exposed to America’s domestic economy

Smaller US-listed companies are trading at a steep discount compared with their larger peers, highlighting how corners of the market remain relatively inexpensive despite the big rally from the depths of the coronavirus crisis.

The S&P 600 gauge tracking the smallest stocks by market value on the index provider’s composite US equities barometer is priced at 14.5 times expected earnings over the next year, according to FactSet data. The valuation is well below the 21.3-times for the benchmark S&P 500 index, which tracks America’s corporate behemoths such as Apple, Facebook and Tesla.

That leaves the S&P 600 price-to-earnings ratio at about 68 per cent of the S&P 500, among the lowest levels since the dotcom bubble at the turn of the millennium. Small-capitalisation value stocks, companies that are considered to be priced inexpensively when compared with corporate fundamentals like book value, are trading at an even steeper discount as investors have piled in to quickly-growing companies instead, according to William Heaphy, head of William Blair’s value equity team.

The valuation gap has grown even as the S&P 500 and 600 have both more than doubled from their coronavirus-induced lows last March, showing how investors need to pay richly to scoop up shares in the biggest US groups.

Small-cap stocks’ more alluring price tag relative to large cap groups, which on the whole are priced at highly elevated valuations compared with long-term trends, has some analysts and investors sniffing out opportunities.

“Despite our forecast for a flat year for the S&P 500, we are still bullish on pockets of the market, including small caps,” analysts at Bank of America said in the Wall Street bank’s 2022 outlook. “Small caps are more domestic, more exposed to the services spending recovery, bigger beneficiaries of capital spending and ‘reshoring’, and are inexpensive [compared with] large caps.”

Mark Sherlock, head of US equities at asset manager Federated Hermes, echoed BofA’s sentiment, noting that “while Covid-risk still lingers, we believe the underlying economy is strong.” 

“This backdrop should benefit company earnings, particularly in small and mid-capitalisation companies which have a higher domestic exposure and a — typically — more local supply chain,” he said.

Investors interested in the UK, meanwhile, would do well to look beyond the underperforming large-cap FTSE 100, said Charles Hall, head of research at Peel Hunt. Companies in the mid-cap FTSE 250 are “far more representative [of the UK economy] and have done much better”.

Boutique hotel group Experimental targets US after €350m investment

Owner of the Hotel des Grands Boulevards in Paris is looking for sites in New York and the West Coast, as well as in Europe

The owner of the Experimental Cocktail Club and the Hotel des Grands Boulevards in Paris will open its first hotels in the US after a €350m investment by one of the world’s largest real estate investors.

Experimental Group plans to open between 10 and 15 hotels by 2024, targeting New York and the US West Coast, as well as about five sites in the UK with the backing of Brookfield Asset Management.

The investment would treble Experimental’s hotel portfolio at a time when the industry is still struggling to recover from pandemic travel restrictions and lockdowns.

The emergence of the Omicron coronavirus variant and the reintroduction of curbs on travel and socialising across Europe and the US are taking their toll on the travel industry’s recovery. Airlines, holiday companies and hotels have all warned this week that demand is falling.

The Brookfield funding has prompted a restructuring of Experimental Group that will allow it to buy hotels outright. Previously the group, which operates six boutique hotels in mainland Europe and one in London, leased hotels and paid for full-scale renovations.

Brookfield has taken a majority stake in a new real estate business alongside Experimental founders Olivier Bon, Pierre-Charles Cros and Romée De Goriainoff and its original majority shareholder Jean Moueix, whose family own the Château Petrus wine estate.

At the same time, the asset manager has taken a minority stake in Experimental’s operating business with Moueix and the founders retaining the majority share. Other shareholders include the investment bank Bpifrance.

Cros said the new structure would allow the company to benefit from its investments: “[Before] effectively I created a lot of value for the landlord and in exchange the only right I have is to pay rent.”

Kenneth Hatton, head of hotels for Emea at property company CBRE, said private equity investment in the real estate and the operating business was becoming more common as investors looked to capitalise from property values and any business recovery from the pandemic.

“Brookfield is a classic investor into this type of space. They take a platform . . . and they provide the capital to grow it as quickly as possible. The reason they want to do that is to capture the recovery.”

The private equity group Fortress completed a similar investment deal with the Irish hotel operator Prem Group earlier this month.

Experimental has already signed terms to buy a hotel in Ibiza under the new structure and has two more under negotiation, one in Rome and another in Switzerland, according to an adviser with knowledge of the deals. It is actively looking for UK and US sites.

Cros said occupancy in its Parisian and London hotels was about 80 per cent and despite a 40 per cent drop in bookings at its Verbier chalet when Switzerland announced in November that all arrivals from the UK would have to quarantine, it had recouped all of the bookings and added more after the decision was quickly reversed.

To survive lockdowns Experimental took about €6m in government-backed loans in France, Cros said, as well as raising “several million” in equity. The company was started in 2007 when the three childhood friends opened the Experimental Cocktail Club.

He added that despite acute staffing shortages in hospitality, particularly in the UK and US, Experimental is aiming to increase its workforce from 600 to about 1,400 with the opening of the new hotels.

The group made €31m in turnover in 2019 but did not give revenues for 2020.

Individually, many of the rules make sense. But taken together, it’s a clear expansion of the government and the Chinese Communist Party, a China expert argues.

China’s authorities attracted the world’s attention during 2021 with a series of abrupt and unanticipated regulatory and policy changes. With several strokes of the pen, regulators wiped out hundred of billions of dollars of equity value, and imposed new and more restrictive regulations on a range of sectors, from internet finance to education.

The reality is that many of the Chinese actions have a reasonable regulatory rationale, and can be easily defended on an individual basis. But taking a broader view, there is no question that the latest government actions represent a substantial expansion of the power of the government and the Chinese Communist Party. Every company that operates in China—including foreign companies—will from now on have to figure out what President Xi Jinping and the party want, and be prepared to respond nimbly. This new hyperpoliticized reality is likely to do long-term damage to the performance of the Chinese economy and certainly poses new risks to investors and business operators.

Let’s take a closer look at some of the new regulations, which not only were plausible, but also, at least in terms of timing, put China ahead of the world. For example, a series of restrictions have been placed on China’s internet giants’ use of data and monopolistic practices. Internet companies face strict new limitations on their abiliy to exploit data gathered from their myriad commercial activities in other kinds of business, including finance.

National data security has been intensified as well, which will almost certainly lead to the delisting of Chinese companies from U.S. stock exchanges since U.S. regulators are requiring more access to Chinese data by auditors, while Chinese regulators are now permitting less access. These measures are controversial, but they also directly tackle issues that developed countries, including the U.S., recognize, but have so far failed to act on.

Moreover, Chinese actions address real issues in the Chinese domestic economy. Chinese internet giants have practiced exclusionary practices even worse than U.S. internet giants; and internet financial services were expanding rapidly into financial gray areas with only the flimsiest of regulatory covers. Chinese policy makers can thus be seen to be addressing their own problems, while also stepping forward as a supplier to the world of regulatory standards, an alternative to the U.S. and the European Union.

If the measures China was proposing stopped here, it would be reasonable to treat them as a new and expansive regulatory regime. But they don’t. President Xi also has proposed a whole host of new political objectives, the pursuit of which involves substantial expansion of the power of the government and the Chinese Communist Party.

New targets immediately relevant to business include technology self-reliance, data security, de-risking the housing market, and getting on a path to carbon neutrality. But other broad new goals will quickly affect business as well. Consider the order de-licensing tutoring companies and requiring them to re-register as nonprofit organizations. This wasn’t for any business reason. It was because President Xi was growing concerned that excessive costs and stress were discouraging Chinese families from having more children.

While new objectives have surged in importance, they have not displaced the overarching goal to which China has been dedicated for a decade: building a world-beating high-tech industrial base. China has already poured hundreds of billions of dollars into industries embodying the technological revolution trinity of data, artificial intelligence and high-speed telecommunications. China has been gambling that total commitment to these new general-purpose technologies will power it on a path to global leadership.

China’s commitment to these high-tech goals has not wavered an iota, but the new policy measures have definitely muddied the waters. A couple of years ago, private businesses knew what the state wanted from them: push high tech and be part of the China team. But now the state is demanding allegiance to a much broader, diverse—and constantly changing—set of objectives. No private business can afford to ignore them, especially since the state has demonstrated its willingness to be capricious and abrupt.

The “summer storm,” in other words, wasn’t just a regulatory storm. Instead, it represented a major expansion of the Chinese state’s reach, which was—to put it mildly—already considerable. While almost everyone can find something they like among the new regulations, it would be foolish to miss the big picture: The Chinese Communist Party is now asserting its right to directly steer behavior in virtually unlimited swaths of Chinese society.

Moreover, nearly all these measures have a direct security motivation: data security; financial security; technological security; supply-chain security; biosecurity. And ideological security. All of the limitations on information implied by the summer’s changes lead directly to tighter control by the Communist Party of ideology and culture. China, at a minimum, is hunkering down for prolonged divergence from the U.S.-dominated world order, ensuring control over its home base, and seeking the ability to survive long-term tension, hostility or even worse.

To be sure, modern states must legislate over a broad spectrum of policy arenas, and national security is a legitimate concern of every government. However, it is also striking that the expansion of the scope of Chinese state power in 2021 has often occurred without appropriate and reasonably effective policy instruments. For example, Mr. Xi has also decreed a push for “common prosperity.” Serious moves to lessen China’s yawning income gaps would require major changes in tax and social-security policy, which do almost nothing to ameliorate inequality in China today. Such policy changes would be effective, and would imply modest costs for business, which could adapt easily to long-term tax reforms. But Chinese policy makers have declined to push for major tax reforms, and instead have instituted a vague program of “tertiary distribution,” which in practice means coercing businesses to raise their “voluntary” charitable donations. Companies in China—foreign and domestic—have had to scramble to initiate and expand programs of social giving. Nobody can afford to be caught out with nothing.

The proliferation of state goals and lack of effective instruments has created a fundamental new reality within China. Every business in China finds itself looking over its shoulder to comply with, or even to anticipate, the changing goals of the supreme authorities. As for state-owned enterprises, they no longer have to worry much about their ability to compete with private companies: They can always claim that their losses were due to their outsize contributions to other government goals.

Real regulatory changes rely on evenhanded and nondiscriminatory rules. By this standard, it is obvious that China’s summer storm wasn’t just a regulatory storm, but something bigger. The winds are still blowing, and citizens—and investors—should brace themselves for more.