New Constructs and Special Guest: Behind the Balance Sheet's Steve Clapham

We're in good shape. We've got a nice crowd here, a lot of folks really excited to have you. I think our agenda is pretty simple. You mentioned you wanted to give a little bit of a background on yourself and an example of a fraud that you've caught, and we'll take a few, few Q&A and We'll for sure allow folks to post additional questions in the private chat for our professional and institutional clients. We can allow a few more people. We can take some questions there now and later. And otherwise, man, the stage is yours.

Okay. How long would you like me to speak for?

At least an hour or 2.

Okay.

Well, just joking.

Just joking. I can talk here.

No, I think, I think 10 or 15 minutes is great.

Okay, well, I was actually planning on speaking a little bit longer than that, but that's perfect. Understand me.

So I imagine that you mainly have an American audience.

I'm in rainy London.

It is pouring down. It is miserable, wet, and horrible. I wish I was in California, to be honest. But a bit about me.

I'm not really a forensic accountant. I mean, you know, people like Carson Block and David are. Leave me standing. But, you know, I've been around for a long time. Don't let my youthful good looks deceive you. And I was on the sell side for a number of years. And then I was asked by one of my clients, which is Tiger Cub, to go and work for them, global hedge fund. So I've been a partner, head of research, partner at Tiger Cub, partner, head of research, 2 multibillion-dollar hedge funds. I set up a trading business just over 5 years ago, and I now train professional investors. That's what I do most of the time. So I'm, you know, I was in this week, you know, a very large hedge fund training some of their new recruits. And next week, I'm training a bunch of very experienced short sellers. And if you're interested in improving your investing skills, I'm sure most of you are professional investors, but a number of people have enjoyed my book, The Smart Money Method. You can listen to my podcast. This month we've got Bill Browder, who has become a justice warrior, but we talked quite a bit about investing. And, you know, here's a guy who ran the most successful hedge fund in the world one year, which is pretty much of an accolade. And I'd particularly recommend James Aitken that we had on in December. Who is just a fascinating macro analyst. But lots of good stuff there. I've got a Substack. You can sign up on my website up there, says sign up. And lots of investing resources. We've got a content hub, and I sell online courses. So we help people improve their skills both in person and online. And those online courses are well worth checking out. We've got the Analyst Academy Pro for people that want to really step up to the next level. And the forensic boot camp, which kicks off on March the fourth, I've just had. I mean, just at lunchtime, somebody emailed me. They did my forensic boot camp back in October. It was the last cohort. They've just been in the interview process for one of the largest hedge funds specializing in long and short side, and this student. Has done come out top on their forensic case study. So they get you in order to get a job there, you have to do a case study. He came top and he emailed me to say, I would never have, I would never have done that unless I'd done your boot camp. So check that out on the website. Or you might actually for the forensic boot camp, you need to email me at info behind balance sheet dot com. And I'm on Twitter at Steve Clapham. I'm on LinkedIn. The website's behind the balance sheet dot com. So in order to detect a fraud, I mean, I think you need a number of tools. You know, obviously the accounting, the ratio analysis is fundamental, but I think you also need help from experts. I'm working on a potential idea at the moment for a $3 billion hedge fund in London. And it is, you know, I'm doing all the accounting, all the ratio analysis, but I also need to speak to experts because some of the nuances when you get very, very deep, and obviously short seller reports are hugely useful. But how does a fraud implode?

And it usually implodes one of 3 reasons. More common than you would think, a short seller exposes them. That's a very, very popular way of them being exposed. Second, a whistleblower goes to the authorities. And thirdly, usually it's when there's an economic downturn, you get far more frauds being revealed. So if you think about the biggest period for frauds in the last, well, in this century, it was in the 2001 to 2003 period when you had the dot-com crash and the economic downturn. And actually almost half a trillion dollars of frauds imploded, starting with Enron and with Tyco, with WorldCom, HealthSouth, Qwest, so on. In the case of No. 3 Patisserie Holdings, the company I'm going to talk about, it was No. 3.

And Patisserie Holdings, its principal brand was Patisserie Valerie. This, you won't be familiar with it in the United States, but this is the typical store. It's a place where you would go to have tea and cake. You might not go, but your mum would go to have tea and cake. And in the summer of 2018, it was one of the hottest UK summers on record. It was the hottest summer since 1976. And this is why Patisserie Valerie blew up, because the finance director, who will be in court in a couple of months, taken that long to get him to court, he was keeping 2 sets of books. One set of books for you, the shareholders, and another set of books internally so that he knew that he had enough money.

And his internal set of books told him they didn't have enough money to pay the VAT bill, the sales tax bill. And he therefore had to borrow an additional—

had to go to the market and borrow an additional slug of money. And obviously, if you've got a very hot summer, it's brilliant if you're Unilever selling ice cream, but it's not so brilliant if you're selling tea and cake.

And that's what happened. And this guy on the right is a guy called Luke Johnson, who's a very highly regarded private equity player and was a principal shareholder in this company and the executive chairman of this company. You're putting your hand up.

Yeah, Steve, did you say— are you looking to present your screen? Because you said this guy on the right and we don't—

we're not seeing it.

Oh, I'm sorry. You haven't— I haven't shared my screen.

That is very stupid of me. Because I've been, I've been talking about all my website and pointing out on the right and— There we go.

Looking good. That's good.

Very, very stupid.

So—

All right. No worries.

That's my website.

Yeah. And I'll, I'll keep track of the Q&A here too if anything comes across.

Yeah. Okay. You shot. So apologies for that.

I—

No worries. So I do that all the time.

Oh, yeah.

It's late in the day for me, you know.

Yeah.

The guy on the right is Luke Johnson, the executive chairman of Patisserie Valérie, and he lost in this fraud, he lost £150 million, $200 million at the time. Not a good day.

Not a good day at all. Did you have a good day at the office, dear? Not exactly, dear. So you can imagine.

But the slide on the right, this is a slide from the analyst deck. And you can see that this is a company that was selling itself to shareholders, right? So it remains an attractive equity story, an attractive market backdrop. The branded coffee shop outlet numbers in revenue expected to grow by 6% CAGR and 12% CAGR. Critical mass already achieved. EBITDA margin at 22%. All stores positive. The concept, you know, 5 proven brands, high-quality products, almost all made in-house from scratch, proven across different store formats and geographies, focused on the rollout, 20 new sites per annum, strong growth, number of stores increased, 250 potential new sites. They were selling themselves to you.

And usually when a company's engaged in selling itself so aggressively, Usually there isn't a lot of good stuff that are hidden. There's no crown jewels hidden in the business. It's all there in plain sight. And the analytical tools, I won't go through all of these, but I'll go through them very quickly. Things like using margin comparisons, I've found to be an incredibly useful Incredibly useful tool. Oh, I've built this forensic accounting course that I give to institutional clients. I spent 6 weeks in the British Library, which has every book in the world in English, and I studied 60 or 70 different frauds. Almost every single fraud had margins which were higher than its peer group and not really explicable. And if you're studying a company, even if you don't think it's a fraud, you should look in great detail at the margins and how it makes its money and the balance sheet ratios. Now, let me just go through one of the things I think is very important is looking at the sales history and how a company has generated revenue growth. And Patisserie Holdings was valued— it was at £114 million of sales at £580 million market cap on 5 times sales.

Why?

Because it was perceived as a growth business. And here's its same-store sales. So the average sales per unit over a 6-year period. And you can see that 2013, it sold 600,000, a bit over 600,000 pounds.

And by 2018, its annualized sales were less than 600,000 pounds.

And this is really, really important because something very, very big happened in the UK in this period.

And you all know what that is. I'm going to ask David, is he paying attention?

What happened?

What was the biggest thing that happened in the UK?

Brexit.

Brexit. And what happened after Brexit? Sterling tanked. And what happens when sterling tanks? Well, we import 80%, 8-0% of our food. So if you're a restaurant and your sales aren't going up over that period, you are in trouble. And so why would you pay 5 times sales for a growth business which wasn't having any same-store sales growth. In actual fact, its same-store sales growth would have had to decline, and its margins would have had to decline given this pattern, or almost have had to. Yet its adjusted EBIT margin went from just under 16% to just under 18% over this period, which is remarkable.

And when you start looking at the margin comparison, I've shown you here the margin comparison at the gross margin level. And this is a very dangerous thing to do because this gross margin looks completely different from its peer group. And there's one very important reason. It's a definitional issue. Because here's the comparison of the overheads. Its overheads are equally higher. And when you look at gross margins, you should be very, very careful comparing one company with another because there is no accounting standard anywhere in the world which defines what goes into gross margin. So every company, even if you look at something, a very, very narrow group like the UK supermarket sector, there are nuances in the way they each report their gross margin. And it's very, very dangerous to look at one company versus another. You can look at one company versus its history, of course. But EBIT margin is the thing where, or EBITDA margin is the thing where you have the the most granular comparison, EBITDA better than EBIT in some cases. But for a restaurant, there aren't a huge amount of assets. I've done it at the EBIT line because this is a remarkable difference.

Here it is making a massive amount more than its 3 principal quoted competitors.

Now, the bottom line there is JD Wetherspoon, which some of you may have heard of. It's affectionately known as Spoons. And it's where students go to have a cheap beer. But it also sells a lot of food. Restaurant Group is a pasta franchise, a pasta outlet. And Fulham Shore, its principal product is pizza, Franco Manca cheap pizza. All of these businesses, they're different nuances in the management. But you can see that the margins are nowhere near those of Patisserie Holdings, which is the red line. The ticker was CAKE. And if you compared Patisserie Valerie with Starbucks, you can see that it was making at one point higher margins than Starbucks and not much distance between them and Starbucks.

And this looked to me to be extraordinary because if you Google Starbucks and get an image, you get an image of a takeaway cup.

Because most people, when they go to Starbucks, they take their coffee away.

And the thing about coffee is it's a very, very high margin product. So here's an illustration. You can't hear, but you can imagine the sound of a coffee brewing in the background, which is a soundtrack to this video. Coffee is one of the highest margin products you can get. I remember going to a friend of mine's pub in Scotland, and it was a Friday afternoon, and everybody was sitting around drinking coffee. And I said to him, well, this is terrible because, you know, Friday afternoon in Scotland, people usually sitting around drinking beer because they got their— collected their paycheck. And he said, oh no, he said, this coffee is my highest margin product. And coffee is a really, really high margin product, about 75% gross margin.

Higher than booze? It's a higher margin than alcohol?

Not just higher, much higher than booze.

Oh, wow. That's amazing.

Of course, we've got very, very high taxes on booze. And, you know, Scotland's not America, you know, it's not a very high income country. So short, you know, you get a short life because It's a very unhealthy country and we have to watch our rugby team who managed to throw the game away at the last minute. But, and this is what Patisserie Valerie was selling. It was selling very intricate cakes with a lot of labor and a lot of cream and the cream goes off. This is a wasting product. It is inconceivable that you could make as much money selling this product as selling coffee. Yet the margins were very similar. But it is worse than that because of the takeaway, because the 2 highest costs for a restaurant in the UK are labour, which is 35% to 40% of sales— of sales, not of cost, of sales— and rents, which will be 12%, 13% of sales. So almost 50% of sales are accounted for by labour and rent. And if you're selling the coffee to take away, you obviously need far fewer staff, and you don't need nearly the same amount of space. So that comparison just couldn't have worked. And this is the comparison against Starbucks. This is a comparison against Costa Coffee, which was a division of Whitbread at the time. Whitbread owned Premier Inns and Costa. These are the margins before the unallocated HQ costs, which which were over 1% of revenues. So the cost of margins are even lower than that. And remember, Cake, Patisserie Valérie, was holding the costs of being a public company, which for a £100 million turnover business are quite significant relative to the turnover.

So all you needed to do with Patisserie Holdings was look at this and you would have said, oh, hang on a second, something doesn't look right.

In the UK, every limited company has to file accounts with Companies House. And if any of your clients don't know this, David, it's a really, really good trick.

If you Google UK Companies House beta, it will take you to the website.

You can just type in any UK company.

You can type in behind the balance sheet. Good luck with that. But you can type in any UK company and it will take you to the filing. So you can look at who owns the company, who are the directors of the company.

How do you do this? How do you do this again?

So if you Google UK Companies House beta—

Pizza?

Beta. Beta as in stock market beta, B-E-T-A. And it'll take you to that website and you can look up any company.

And what I've done here is I've just shown you Cafe Concerto. Which— so you can see that's a picture of its window, and you can see it's exactly the same products as Patisserie Holdings. And you can see what I've done here is I've compared Patisserie Holdings, the red line again, with some of its peers, some of its unquoted peers. So these are just limited companies in the UK, but I've just downloaded the accounts and just plotted the margins. And this is a really useful tool because There's, you can, you can look at a very, very narrow segment. You can look at a particular type of retailer. So that dotted blue line is Paul UK, which is probably the closest comparator selling the closest products. And you, you can see that it makes no money. Caffeine Concerto makes no money. Joe and the Juice, which is owned by the Danish government for reasons I can't even begin to understand, is making massive losses. But here's Caffe Nero, which is a similar concept to Starbucks. It's a predominantly UK concept. And you can see that over this period, its margins went from just under 10% to under 5%. Its margins halved over the same period. Now, it's possible that Patisserie Holdings could have seen its margins go up while Caffe Nero's margins halved. It's not impossible. Could be something specific with Caffe Nero. But you would have to ask yourself why. And there's some obvious signals here. And when you compare things like employment costs to sales, Patisserie Holdings had amongst the highest employment costs. It had higher employment costs to sales than any of its unquoted peer group. And it had very high rents to revenue. So its rents were one of the highest of any of the quoted companies. So it's very hard to see if your labor is higher and your rents are higher, and those are the 2 largest cost items, it's very hard to understand why would your margins be higher. And then I've just done a few other charts here showing cash generations relative to earnings. For a service company, it's not always appropriate to do the the receivables days, the inventory days, the payable days. And what I've just done here is looked at the cash generation relative to earnings, and I've looked at the current assets minus cash relative to sales. So you can see here that it's making very, very low, generating very little cash relative to its earnings. And you can see Starbucks isn't a particularly strong performer either, which is quite interesting because you would imagine that Starbucks, you would have thought, was a very high-quality business, apparently, just looking at the stock price and the multiple. But yet other restaurants are much more cash generative.

And this is the current assets minus cash.

And you can see that it's got a huge amount of assets relative to sales, relative to its quoted peers. And the reason is very simple.

It was a fraud. And here's the inventory days versus cost of sales. And you can see that it's got almost 90 days of inventory. This isn't old croissants and old cakes. What this is, is raw materials. 5.3 of the 5.6—

of the $6 million of inventory was raw materials and consumables on $114 million of revenues.

And I didn't know what those consumables might be. So again, I go back and I look at a very close competitor. I look at the UK Companies House filing, Paul UK, and you can see it had £35 million of sales and a quarter of a million pounds of stock. So Patisserie Holdings, 3 times the sales, 20 times the stock holding. Obviously, something didn't look right. So lastly, just I really, really like using per unit measures. Very useful tool to detect valuation anomalies, to detect accounting shenanigans, and to detect frauds. And you can see here that Patisserie Holdings had a massively lower sales per unit than its peer group. Fulham Shore, the pizza company, almost a million. Restaurant Group, almost 2 million. Wagamama, 2 million.

And here's the valuation. You were paying £2.7 million for a cafe in a local high street in England. I mean, just off-the-charts stupid. You could only justify that if you felt that there was huge scope to roll it out and the margins were really sustainable. It was more than twice, 2.5 times the quoted peers. Wagamama was an acquisition from private equity by Restaurant Group. Stupid, hugely overvalued, obvious deal. Using per-unit valuations, very, very powerful. So the conclusion of all this, doing the analysis reduces your risk. So I'll leave it there. I hope that's been fun and useful and interesting. Terribly sorry for forgetting to show you the slides at the beginning.

No worries. We got a couple of questions. Steve, from Bruce, what are your thoughts on ESG, sustainable investing, impact investing, clean tech, and SFDR, etc.?

I don't know, even know what SFDR is.

That's—

I don't either. What is SFDR, Bruce? Can you type into that? And by the way, everyone, I encourage you to enter your questions into the Q&A.

So Bruce, thank you for it. Thank you for that question. I don't know Bruce, and but I'm very pleased that he's teed me up because today, and in fact eight minutes ago, I sent out a newsletter to my Substack subscribers. I've launched and I'm launching a new podcast, which the first one will go out a week tomorrow on March the first.

And we're looking at how do you make money out of the energy transition. There's a lot of garbage talked about ESG.

I mean, a huge amount of nonsense just talked about it. To me, G, governance—

who makes an investment without looking at governance?

I mean, if you're an institutional investor, how can you possibly make an investment in a company that's not properly governed? You have a fiduciary responsibility, right? S for social. I don't really understand why I would have anything to add or anything to offer in that perspective.

I'm investing in companies and I expect them to understand diversity. I don't really care whether you've got 1, 2, 3, 5 women on the board. I mean, I expect them chairman to make sure the board has got a proper diverse set of views from people that not only don't all look the same, but don't all think the same. And, but the E, I think, is fundamental and hugely, hugely important. And so that's why I've teamed up with Hugh Van Steenis, who's a climate finance expert. He used to be an advisor to Mark Carney when Carney was the governor of the Bank of England. He then became an advisor to the chief executive of UBS. He's a former bank's number one banks analyst. And he's now the vice chair of Oliver Wyman. And we're going to be interviewing a bunch of really, really smart, slick people and talking about, well, how do you make money out of the energy transition? And, you know, what's happening with climate change? So—

I'm a big believer as well, Stephen, in the G. I think the G is by far the most overlooked element of ESG because You know, if you don't get the E and the— well, no matter how good your E and your S are, if you don't have a sustainable business, you don't have good G, well, that E and S is not going to persist, right? It's not going to be sustained, right? So the G is important to the sustainability of whatever you're doing on the E and the S side. And so I'm with you, you know, and G to me is all about good capital stewardship.

Yeah.

No, I mean, I mean, I think G is a given before you You know, before you start, here's what SFDR, by the way, stands for.

This is a— this is the EU has put in place a transparency framework. This is from Bruce, the Sustainable Finance Disclosure Regulation.

All right.

Okay. Well, I better swot up on that because I'm, I'm doing a newsletter along with the podcast. My idea has been to sort of educate myself and do this sort of Learning in public, and so I'm going to be I'm going to be learning. So there's a lot.

We got a couple. We got some more questions. There's some more questions. Do you find sell side analysts are good at this type of forensic analysis on their respective sectors?

That's a joke, right?

I was gonna I was gonna say that's a big no. That's not their job. We've talked about this. Our audience should know better. Shame on you guys. You know that the sell-side analysts not in the business of informing you, they're in the business of helping the bank sell stock because that's how the bank makes money. They don't make money on research. So sell-side analysts blowing up clients, not a good thing.

Great quarter, guys.

Another one here from Jake. Uh, what accounting rules are currently being clarified through GAAP/IFRS that will expose companies that are using aggressive assumptions?

I'm glad you asked this, Jake, because I have— I'm really, really disappointed in the way that the Accounting Standards Board over here has been. I mean, it's been a dismal failure, in my view, to do exactly this. So there are a lot— there's a lot of cheating, a lot of earnings management going on in the US. People are being paid too much, and they, you know, if they want to make their quarter, they want to make their options, they're getting too many options, and they're being incentivized to cheat. So, you know, the system is rigged against you, the investor, but you've got the SEC, and the SEC at least are very effective at trying to plug holes. So the biggest one recently was factoring. So huge number of companies using factoring and reverse factoring. There was a huge— I mean, I'm a great believer in looking at the supply side, you know, the capital cycle. And because we had negative interest rates in Europe, so if you were a company, you were having to pay to keep money in the bank. What a lot of corporations were doing was finding anywhere, any home for that money that they didn't have to pay interest on it. And so a lot of that money was going into new intermediaries, you know, so tech startups, fintech startups to lend money in both factoring and reverse factoring. So there was a huge wave of it in Europe.

In spite of that, we have been very ineffective at requiring companies to disclose it.

So if you're a company operating under IFRS, there is no obligation to tell your shareholders, your credit holders, your investors, your suppliers that you are using factoring and that your working capital is understated in the balance sheet, which seems extraordinary.

The SEC at least requires companies that are factoring to disclose this in the cash flow statement. And the factoring, the amount that they've received from factoring has to be separately disclosed in a separate line in the cash flow. They put that line under the investing, which I don't really understand why it's not under financing, but at least they disclose it. In Europe, a year ago, so SEC has been doing this, I don't know, for 3 years. I don't know if you know, David, when they introduced that, but They— last year, I looked at an exposure draft, an 83-page document discussing how we might better disclose factoring and reverse factoring. They are staring at their own navel, trying to work out the most attractive theoretical solution to the problem. Whereas at least in America, you say, we don't really care if it's theoretically elegant. We just want to make sure that our capital markets are protected and that investors can understand what's going on.

You're giving, you're giving the SEC a little bit too much credit, my friend, as well as the, the, the Financial Accounting Standards Board. I worked with the Financial Accounting Standards Board for 5 years and have been to meet with the SEC. Maybe they're doing a better job than, than, than UK regulators, but there's, yeah, there's a lot to be left to be desired and it's better. But I think the answer to the question is no, there's not really I think there's a lot of stuff that's kept off balance sheet. But I mean, you know, to your point, they are requiring some more disclosures around it. The companies can— they just stay one step ahead. I mean, on the margin, there are more disclosures in the US. You're right about that. And that we should take credit for that. You're right.

I mean, I'm not saying the SEC are doing a good job, pat on the back, go home, boys, put your feet up. Just to be clear, there's a lot— there's still a lot that should be caught. But relative to other jurisdictions, America is doing miles, miles better. And I think, you know, in Europe, it's honestly pathetic. I mean, really is.

And of course, most of the Asian companies are reporting under IFRS.

So for most of the world, no, it's not good. Not a good situation.

Yeah.

Mark is asking what—

and by the way, Bruce says he loves your book.

Oh, well done, guys.

You got some good fans here, Steve.

You're well known.

You're an international star here. Another question from Mark. What metric is the most useful in scanning for malfeasance in earnings?

Well, I mean, I don't think you can say that there's just like one metric because obviously it depends on what companies are doing.

But I do like the margin comparisons. I do like looking at the working capital ratios.

I like looking at the audit report. One area where we've actually been better than the Americans is in the audit report. So I think in the US, the audit report was required to disclose areas of disagreement or judgment, areas of disagreement with the company or areas where they thought there was a lot of judgment, I think from 2019. Whereas we've had that probably for 10 years, and we've got several different things can be disclosed. Where in America, the auditors usually only disclose one thing or maybe 2 things. But the audit— don't overlook the audit report because the audit report will always tell you that there's an issue.

So if you open the Netflix audit report, it says, you know, the estimation of the value of content in the balance sheet is a very subjective issue. And it's quite useful, especially if you're looking at a new company, to start there. Because if there's something that's very subjective, you should spend time understanding to what degree the company's got the ability to move its earnings around. But I don't think there's one thing, Mark. You need a whole suite of tools. And we talk about 8 different basic accounting red flags that we look for when we're looking at a company, apart from the detailed, more forensic analysis.

Yeah, you know, I think that's for sure right. I think one of the things that New Constructs brings to the table, Stephen, is that when you can compare our core earnings to accounting earnings or our economic earnings, because we take into account all these things from the income statement, the balance sheet, the cash flow statement, and the footnotes, You need a lot fewer metrics. You know, when I was— when the Harvard Business School and MIT Sloan people were writing the paper on our data, they talked about a couple of techniques, and I'm blanking, the Z-score, maybe Altman Z-score. And what that was is a sort of what I would call an old-fashioned way of trying to detect quality of earnings because you need 7 or 8 different accounting ratios to try to get to the same thing if you don't read the footnotes.

Yeah.

And so I think in some ways I like to believe new construct simplifies that, providing effectively a cleaned-up number to compare against the reported number. That's, I believe, one of the best red flags because my sense is, and I'd love to know your opinion on this, Steve, is companies tend to bend the rules before they break the rules. So when we see a divergence between our numbers and the company's numbers, We think that's where you want to start maybe focusing in.

No, I think companies take huge liberties with adjusted EBITDA, for example. And I don't quite know why. I mean, I was slightly puzzled because you would imagine that the credit analysts would've been much stricter than they have been on this. I was writing about Kantar the other day. Other week, which is a private equity-owned UK-listed minority— UK-listed company's got minority in it— and the EBITDA has got, you know, pro forma run rate cost savings. And you think, well, how do I have any idea whether that's a, you know, a reasonable number or not? And this is, you know, the only reason that anybody's interested in its numbers is people that have lent to it.

You know, it's got no equity.

It's all private. The equity is all private. It's only the credit that's available. And you would imagine the credit analysts would be more sophisticated, but they seem to be—

They're not any different, man. They're not any different. I mean, look, you're not attracting the same level of talent, you know. I mean, do you have any famous credit analysts? I mean, I was on Wall Street. You didn't even know the credit analysts existed. The equity guys got all the glory. So yeah, and, and look, you know, we had to— at New Constructs, we couldn't even use credit ratings. We paid for credit ratings from S&P, and the numbers we got sometimes were so far off from our own analysis of debt to total capital, right? We were looking at companies that had AA, AAA, whatever, like really good credit ratings, even though their debt to total capital, when you took into account off-balance sheet debt, was 80%, 90%. We're like, this is ridiculous. We can't do this. You know, we can't use it. So we, you know, we had to create our own credit rating just so we could have decent equity models. So you're right. You know, and I think so much of where you and I agree, Steve, is that there's so much work that traditional analysts should do, but they don't do. And the signs of fraud oftentimes are ridiculously obvious if anyone's doing the basic work. But guess what? They're not doing that kind of work because they're in the business of selling stock, not really warning investors.

No, sure.

We got another great comment here. I can't tell if it's a question or a comment for Joseph, and I think you've already answered it because he says, what do you think about the letter to shareholders and the auditor's report, which I've come to think of as gifts in terms of screening companies? You, you know, for example, Netflix content amortization, Mag 7's extension of useful lives of its servers and network assets. All of which were discussed in the auditor's report. We agree. I mean, we take a look at the auditor's reports too at New Constructs. In particular, we like to identify when the company, when the auditors are raising concerns around internal controls. We think that that's absolute gold. A question about the importance of NRR for growth software companies or net revenue retention. How can we identify companies that are gaming that? That's from Jake.

Well, there's a whole slew of new type of parameters that really don't get proper attention from the accounting community. And this whole issue of churn, I actually, I've got a module that I do sort of an optional module in my forensic accounting course I do for institutions about how to game your churn and those sorts of data.

And I can tell you, churn is the thing that is really, really significant for these companies. And, you know, I've got an internet business, so, you know, I know all about this from my own practical experience. And I can tell you that some of the things like lifetime value calculations, they're absolute nonsense. I mean, just, I mean, when you ask companies and you sit down with them, you say, you know, just run me through how'd you calculate this lifetime value? And they honestly, they talk absolute nonsense. So It's very difficult to identify the gaming because there aren't any ratios you can use. The only way you can do that is by understanding the companies really well and by using expert networks and hearing what the real churn is. I find in these sorts of circumstances, speaking to the competitors is also very, very useful because the competitors generally know the way that their competitors are gaming. But there aren't any accounting numbers. You know, when they say our net revenue retention was, you know, 89% last quarter, there isn't a number that you can look at to check whether that's right or not. You know, you always—

the only thing—

So much of what we do has to rely that they're actually telling us the truth in the financials. And because I get that question a lot, like, hey, how well do you detect fraud? Like, well, I mean, we don't— if they're just blatantly lying about what they put in the financials, I mean, it's hard to know.

Yeah.

So I mentioned before, you might see them stretching the rules before they break the rules, and that's a good indicator. But when someone's just lying about the numbers, the only way to kind of know is to do what you do, Stephen.

But I mean, things like the NRR gaming, If you look at it quarter after quarter and you look at what they're saying and you look at the revenue growth, you can back out what that means in terms of new customer acquisition. And you can then compare that to what's the marketing spend doing. So you can, if they're outright lying, then what you'll see is that they're exaggerating that NRR number and the marketing spend is going through the roof. And they're not adding new customers. So, you know, they can't have it all ways. So you can usually kind of square the circle by doing enough work. But that on its own, there's very little you can do about.

Yeah, agreed. One last question before we wrap up here. Do you use the Beneish M score? I've never heard of this.

Beneish M score? You don't use the Beneish M score?

No, I never heard of it.

You're missing out.

So the Benish M score is— it was designed by Professor Mesod Benish. It uses a number of the parameters that were originally designed by James Montier, who now works for GMO but used to work for SocGen with Albert Edwards. And James came up with the Montier C score, which is a 6-part score The Benyish is an 8-part score, and I think the Benyish M score is very useful. The problem with the Benyish M score is you get a huge number of false negatives. So it indicates companies that are cheating that are fine. And in my forensic accounting course, I give examples of companies that score badly in the Benyish M score. And one of them, one of my clients said, That— why is that company on the list? And I said, well, I don't know. I mean, I've just given you the screen.

You know, this is— it's the screen spits that out as being an offender. And the client had a massive holding in this company.

I mean, like several percent of it.

And she said, oh, well, you better go and look. And I then went to look and I opened this set of accounts and I knew the chairman. The chairman was a personal friend of mine. I didn't know that he'd been appointed the chairman. I hadn't seen him for a while, and I had to, you know, I had a quick look and I called the client up and said, look, I think this is one of these false negatives. And so that's the problem with the Benishem score. It might keep you out of a lot of bad things, but it would also keep you out of a lot of things that were otherwise very good. So you just got to be careful.

It's like a lot of economists, they've predicted 10 out of the last 3 recessions.

Yeah.

Well, Steve, I think this has been great. I think if you're okay, say a few words, we can wrap up and make sure you've got your contact information up there on the screen for people to see. And I've also got a private chat in our online community, the Society of Intelligent Investors, where people can follow up with questions. And if they want a meeting with you, I will forward that information over to you as well. Or you can, you know, you can join the society as well and see all that.

Oh yeah, I must do that. Yeah. Yeah.

Anyway, yeah, let's, let's wrap it up here. And I think it's been a great session, very well attended. People are dropping off as we speak. So, because they hear me coming to an end here, but anything else you want to say and we'll, we'll wrap it up.

No, just David, I just say thank you very much for having me. It's always fun to talk to people, get these smart people's questions and well, maybe we'll hang around and have a chat after.

Yep. We can do that on a, on a different, on a different platform. I think the webinar kind of either closed it for everyone or no one. So, but I think this has been great. Yeah, absolutely. We got some, you know, one Bruce, Bruce said he'd love to learn about the society and to be in touch with Stephen. So yeah, everyone check out Stephen's contact details right here. Society of Intelligent Investors. You can go to our website, go to learn more. You can join there and otherwise send an in— you know, emails into support@newconstructs.com. We'll make sure that you get directed to the right place. Thanks, everybody. Great show.

Thank you.

Thanks, Stephen.