How investors could have avoided the Supergroup debacle

I just hit the office to pick up the news via Twitter that the company that owns the ‘Superdry’ brand so beloved of the fashion glitterati ( Supergroup (LON:SGP) ) had just announced a rather spectacular and unusual profit warning - announcing profits would be about 14% below their previous estimate. As is to be expected the once high flying stock has seen its share price cut by a massive 31% since yesterday’s close - investors in the stock must be feeling incredibly burnt. What many of them won’t have known is that there’s a little known statistical indicator which had been screaming that this might happen for about the last six months.

Before we go into that, lets just take a closer look at the statement from the company which makes quite painful reading.

The Group expects profit before tax for the full year to be approximately £43m. The most material reasons for this are: There have been arithmetic errors in our forecast of the Wholesale business amounting to some £2.5m. Also, the Wholesale business is multi-dimensional, experiencing high growth levels and, given our rapid expansion and lack of history, it is difficult to predict accurately. There is a shortfall in the current year of some £2.0m due to the particular timing of pull-down of stock over the year end period by both franchise and wholesale customers. As this is largely a timing issue, the majority of these sales will fall into our FY13 result.

To put it mildly the company is admitting its not accounting for its growth particularly well, and stating ‘arithmetic’ errors doesn’t exactly inspire the greatest confidence in their finance department. Peel Hunt apparently stated “We have no confidence in delivery or market expectations, and struggle to see the shares as being investible.” and Singer stated the bleeding obvious “This latest calamity in SuperGroup’s short life as a listed company is not going to be well received”.

But dear Professor Messod Beneish had been statistically predicting this calamity all along. In June 1999 he published a paper called “The Detection of Earnings Manipulation” where he outlined an indicator he came to call the M-Score. The M-Score is calculated using a weighted formula consisting of 8 financial ratios that aim to capture the typical signals of high earnings manipulation risk companies. Some of these are expected - such as extending longer credit terms to customers - while some are more unexpected - high sales growth is a strong contributing factor. The full details can be found in the above paper or our summary here.

As we calculate M-Scores for the entire UK stock market as a key part of our Stock Reports we’d been discussing Supergroup’s appearance on the high risk list just earlier this week. The M-Score for Supergroup was –1.22 well above the –1.89 threshold for high risk. Our checklist indicates that Supergroup was showing the following especially high Beneish risk factors- receivables increasing strongly as a proportion of sales, excessive sales growth and high accruals as a proportion of assets.

 Special Offer: Invest like Buffett, Slater and Greenblatt. Click here for details »

I found the most interesting sentence in the Supergroup statement that ‘this is largely a timing issue, the majority of sales will fall into our FY13 result", raising the question as to whether some of the finance team there may have been booking sales too aggressively for 2012.

The lesson to take from the Supergroup debacle today is that investors need a good toolkit to avoid these kinds of horror situations. As the only website in the world that offers the Beneish M-Score as a standard component of stock pages our subscribers have been well warned about the risks here - and there’s plenty of others out there that one should be aware of. Take heed - it may not worth taking the risk in situations such as this! If you want to try a 2 week free trial to Stockopedia Premium click here.

PS - I've unlocked the Supergroup Stock Report for the day - try clicking the pop up in the right column - the full checklist is below: