The RAAC scandal's lessons for investors

That may change. But beyond the hunt for accountability, the episode should be a reminder of some big lessons for investors in companies. Although organisational goals differ – schools exist to educate, businesses to make profits – there are close parallels between both.

The first is that when cash is too tight, all priorities defer to survival. For businesses, building long-term resilience is only possible when there is surplus capital or positive cash flow.

Shares in De La Rue (DLAR) have nearly doubled since the authentication group renegotiated its debt and pension fund contributions at the end of June, without which covenants would have been breached, jeopardising its status as a going concern. In pushing the shares' value to 20 times forecast earnings – twice the five-year average – investors appear overly focused on the short term, and suddenly insufficiently concerned with the questions that have dogged the company for years.

Paradoxically, while a focus on the present can sharpen minds and create value, it risks creating gaps. Herein lies our second lesson: investors, like good businesses, need to pay attention to the things no-one talks about.

Stock markets, as with education, are often heavily steered by headline results, and how this year’s grades or earnings compared with last. Less time is reserved for looking at the boring stuff that allows any of this to be achieved in the first place, and the addressable risks that could bring it crashing down.

Take cyber security, an area where companies can exercise control, albeit at a cost that is rarely acknowledged unless disaster strikes. From the outside, it is impossible to say how much blame Capita (CPI) should shoulder for the March cyber attack that has cost it up to £25mn. But the fact that some of the £25mn will “reinforce” the outsourcer’s digital defences suggests further gaps were found. The incentives to take your chances on certain gaps – including from shareholders – will rise if your operating margin rarely exceeds 4 per cent.

Third, beware of certain corporate stewards. Although private equity isn’t homogenous, its ownership model is all about maximising cash flows to boost an eventual sale value. Debt is the best-known way sponsors do this; another is to cut back on spending that isn’t earnings-accretive. This isn’t to imply private equity is negligent, but that its incentives are skewed to wringing out as much value from capital assets as possible. This has trade-offs.

Fourth, and perhaps most importantly, is that continuous capital spending matters, regardless of whether it delivers an immediate return on investment.

It is hard to be formulaic here. While FactSet data suggests around three-fifths of companies in the FTSE All-Share have separately reported maintenance capex in the past four years, this figure alone won’t tell you where a company sits on the continuum between overspending and presiding over concrete death traps for years at a time.

Knowing a company’s depreciation policy can provide a bit more insight, although not always. Investors in Vodafone (VOD), for example, must make do with the disclosure that equipment, including network infrastructure, is written down at some point between one and 35 years.

A better measure is a company’s capital expenditure to cash profit (Ebitda) ratio, which gives a sense of continual investment and business futureproofing. Encouragingly, the average All-Share constituent has pushed this metric from 20 per cent four years ago to 27 per in the most recent financial year.

Some of this rise will be spending delayed by the pandemic, or because of UK subsidies that are now ending. As other business needs increase corporates’ competition for cash, we might expect it to dip in 2023. Then again, should executives require a reminder of the need to continually upgrade, refresh and secure their existing asset base, they only have to look at the condition of the UK state.