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Signals and morals

Created:
8 July 2008
Updated:
15 July 2008
Written by:
Mr Bearbull

Bearbull's portfolio log, dateline 20.6.08: "Why are Southern Cross shares so weak (down from 420p to 350p)?" Believe it or not, that's a true entry. It was made at the same time as I noted that shares in microprocessor designer ARM had fallen into my buying range and those in models maker Hornby were even further into buying territory.

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However, it's shares in nursing homes operator Southern Cross Healthcare that I need to focus on. Having topped out at 422p in early June, they dropped into the buying range - so I bought 7,500 for the Bearbull Growth Portfolio at 379p - but they then just kept on fading. The market was telling me something. I picked up the signal, and it got louder. By the time Southern Cross announced lousy news on 30 June, the price had fallen to 313p. But I did not bother to figure it out. As a result, I am nursing a 79 per cent loss on my holding as Southern Cross's shares languish at 80p, and the growth fund has suffered its worst month since April 2000. So what's the investment moral?

First, beware of debt. That's not such a statement of the obvious - not long ago debt on a group's balance sheet was assumed to create value. Even so, too much debt has always been a problem and, right now, even a little can count as too much.

The good thing about Southern Cross is that its business model could eschew debt. That is because it seeks to sell on the freeholds of nursing homes that it has bought and manage the homes on long-term leases. But this tactic has really just paved the way to grow fast by debt-financed acquisition. As a result, in 2006-07 the number of beds it managed rose from 29,000 to 36,000 and net debt rose from £68m to £171m. For its business model to work smoothly, though, there must be property investors with access to funds who are keen to buy Southern Cross's freeholds. Back in December, chairman William Colvin, who is now the chief executive, was in no doubt that this would continue to be the case. Alerting shareholders to the plan to accelerate growth by acquisition, Mr Colvin said: "Our landlords and banks are supportive, and our covenant remains sought after and strong".

Well, after the events of the past 12 days, less sought after and less strong. Arguably, what really spooked investors is that Southern Cross could not repay £46m of short-term debt that had become due because it could not sell a batch of freeholds. This implies that the property investors are no longer there or they won't pay the prices that Southern Cross needs. Whichever, it is bad news for Southern Cross.

But, clearly, would-be property buyers can hardly be encouraged by news of current trading. Just six weeks after talking bullishly about increases in fees and the prospects for occupancy levels in its 730 homes, the group's bosses have now decided that delays in receiving higher fees and disappointing occupancy levels mean that profit for 2007-08 will undershoot budget.

Sure, the unexpected happens and it's the responsibility of a listed company's board to report it quickly to the market. Even so, the impression that Southern Cross's board does not know its bed pans from its Zimmer frames brings us to the second investment moral: beware of too many changes at the top.

In the past eight months Southern Cross has got through two chairmen, two chief executives and three finance directors (one of whom lasted just four months). It has also promoted its operations director to managing director, before appearing to shove him sideways also after only four months. Nor does it help that the non-executive director appointed to replace Ray Miles, the senior independent director who is now the chairman, does not look independent. From 2003 to 2005, Nancy Hollendoner was a non-executive director at nursing homes investor NHP, where Southern Cross's Mr Colvin and executive director John Murphy, plus its new finance director Richard Midmer, ran the show.

Still, at least some directors are putting their money where the mouths are and buying Southern Cross shares at their depressed level. Whether this is a sign that investors should follow is questionable, however. Last December, Mr Colvin, Mr Murphy and other bosses sold £37m-worth of shares at 550p each in advance of changes in rules for capital gains tax. They also pledged to re-invest in the group's shares to the level of three times their salary "at the appropriate time". That time came in January when Mr Colvin bought 500,000 shares and Mr Murphy 450,000 at around 385p each. Clearly, had they had any notion of the group's immediate trading prospects they would have deferred their purchase. So they get full marks for honesty, but nothing for prescience, which makes their latest buying signal fuzzy to say the least.

And that's a third investment moral we can take: that director's dealings don't necessarily provide a reliable investment signal. Yet who am I to criticise Southern Cross's bosses? After all, Bearbull's signal to buy was as faulty as theirs.

Still, I can afford to be fairly relaxed about these losses I am running in the growth fund. That's because the wonders of portfolio diversification mean that this particular drama won't turn into a crisis. And that's the most important investment moral of all: diversify.

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