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Five learnings from the demise of Steinhoff

Like many of those in the South African investment industry, we at Perpetua have spent a great deal of time internalising and processing learnings from Steinhoff Holdings’ massive corporate failure.

Our clients largely had a negligible to nil exposure in the stock for the past 5 years as we have for some time had concerns over the business, and its governance (hence our historically low/non-existent holding). Despite this, we acknowledge that as part of the broader investment community we need to fully grasp the extent of the ramifications of a corporate and investment failure of this scale. This is compounded by the fact that Steinhoff was a widely held and even popular stock; featuring in the top holdings of many active fund managers as well as passive managers given the stock’s high index weighting.

Over the short term little good is likely to come to those investors who have permanently lost their capital. However, the investment industry need not wait to distil the grave shortcomings in Steinhoff to ensure that should we see similar signs in other investments we might own or consider owning, we must act with a knowing caution.

Five of our key learnings

The extent of the mismanagement, accounting irregularities and alleged fraud at Steinhoff are still to be fully uncovered. In the first annual meeting of shareholders on 20 April 2018 post the collapse of the company, the board itself indicated that one of the key priorities of the business is to “uncover the truth”. It is almost incredulous to believe that a company which some six months ago was one of the ten largest shares in the South African stock market (and the 3rd largest share just two years ago) could be now trading some 95% lower, struggling to survive as a business.

While hindsight is always perfect, we believe some of the warning bells were actually there for some time and if these were contextualised with the right caution and scepticism, more questions could have been asked by many more investors and sooner. Had this occurred it might have forced the company and its board to be considerably more alert to the state of affairs than they ultimately turned out to be.

Outlined below are some of our key takeaways for what we believe contributed to Steinhoff’s demise and the questions we might ask going forward when facing similar circumstances:

The lack of true board independence and governance

Since its listing in Germany in late 2016, Steinhoff adopted a two-tier board structure which is consistent with Western European corporate governance guidelines. A two-tier board comprises a management board (made up of executives of the business) and a supervisory board (comprising nonexecutive directors). The rationale for this is to ensure independence between the management of a company and the non-executive board directors.

The irony of the two-tier structure in the Steinhoff case has turned out to be that separating management from non-executives directors actually served to disservice the non-executives who appeared to be suffering from a vacuum or asymmetry of critical information to which the executives were privy and thereby concealing in part reckless actions.

Further, despite rated credentials, depth of experience and qualifications, it was the true independence of Steinhoff’s non-executive directors on the supervisory board that was frankly questionable. This was evidenced by the fact that many of the non-executive directors were either known associates, family members or friends and admirers of majority shareholder, Christo Wiese or original founder Bruno Steinhoff. This resulted in a situation where it appeared the interests of the company and the board were more aligned to management and selected influential shareholders, than to all shareholders as a whole.

Questions to pose/ warning signs to look for:

  • Are there sufficient number of board members who have no connection to the company or its key shareholders/founders/management whatsoever?

  • Are truly independent, unconnected, nonexecutive board members sufficiently represented on the various key board committees such as the critical audit and risk committees?

  • Is the board sufficiently diverse in terms of backgrounds; demographics; hailing from a variety of disciplines and experiences, such that group think can be minimised?

  • What is the level of cross-directorships held by board members?

An overly domineering, highly persuasive CEO

Steinhoff’s CEO, Markus Jooste was a persuasive, strong-willed, tactician of a CEO. His convincing, talkative and overly confident manner served to create an enigma in respect of his conduct. This in turn enabled him to escape with explaining even the most necessary of decisions in a superficial and even dismissive manner, yet eliciting scant criticism or scepticism for this behaviour from the majority of his audience.

The resultant impact that an individual of Markus Jooste’s domineering character had was to effectively enable his otherwise astute audience (which predominantly included mighty bankers; prudent auditors; experienced existing and potential investors and learned board members) to suspend normal sceptical judgement and trust him almost blindly. With this trust in the palm of his hand, we have now discovered Jooste went on to engineer and conceal a web of irregular and evidently fraudulent transactions over a period of many years right under the very noses of this typically perceptive and sophisticated audience.

Questions to pose/warning signs to look for:

  • Does the CEO actually answer questions in a substantial manner or evade/avoid them?

  • Does the CEO dominate in meetings/presentations, to the point where he is the main responder to questions that that CFO or COO or other executives should be answering? Added to this does the CFO, COO and other executives actual defer and deflect questions they should be answering to the CEO?

  • Do market participants behave in an inexplicably “infatuated” way in respect of the CEO and his capabilities, thereby tacitly promoting his behaviour?

  • How much obvious hubris does the CEO objectively display relative to his/her peers?

A constantly changing business strategy

When examining the business strategy of Steinhoff over the past decade and especially the past five years, it would be safe to conclude it changed regularly, often in an abrupt or reactive way as opposed to a deliberately pre-emptive manner.

In 2017, major shareholder Christo Wiese defended the spate of random acquisitions stating that the pace of deals concluded over the past few years was “purely an accident of timing” and blaming it on “Steinhoff’s DNA” of opportunism and nimbleness. The trouble with this narrative is it can effectively justify any investment or strategic decision, and so it did.

A track record of overpaying for acquisitions, especially very large ones, was also a feature of Steinhoff’s behaviour.

Questions to pose/ warning signs to look for:

  • Does a company’s strategy flip-flop over a period of time?

  • Do the board members actually question the executives on the basis for material deviations from their publicly stated strategy? What explanation would be plausible?

  • Do board members interrogate the inflated purchase price paid for large acquisitions and what the basis for determining purchase prices?

  • Are explanations such as “being opportunistic”; “it’s in our DNA” used to justify strategy changes?

  • Do shareholders truly hold the board to account for how they allowed vary their stated strategy or do they simply go along for the ride?

Opacity in financial disclosure

Steinhoff’s financial disclosure was opaque. This was exacerbated by the complexity of the business itself operating in multiple geographies and several subsidiaries; and the highly acquisitive nature of the business. The level of share issuance was extreme and the consequent financial engineering was impossible to keep up with. Divisional breakdowns changed frequently and when interrogated on the detail of financial due diligences of acquisitions, Jooste would often claim he focused on “human due diligence” in acquisitions not the usual tedious, numerate components.

Questions to pose/ warning signs to look for:

  • Does the company regularly change the basis for its disclosure?

  • Are their inconsistencies between stated results and actual business performance through a host of adjusting entries?

  • Are reported earnings easily reconciled to actual cash flows?

  • Is a company’s effective tax rate materially lower for an extended period of time, bringing quality of earnings into question?

  • Does a company enter into complicated financial transactions especially at times of its acquisitions?

  • Does management blame the size; scale; complexity of the company’s operations for not being able to conclusively respond to questions posed?

Dismissal of its critics

Markus Jooste as CEO; Steinhoff as a company and Christo Wiese as a majority shareholder did not take kindly to critics. Ironically some of Steinhoff’s shortcomings and vague disclosure had been identified by some (albeit the minority) of market participants over the years. These were both buy side investors and sell side stockbroking analysts.

For the traditional buy side investors, concerns were typically fully expressed in the act of not investing in any material way in Steinhoff, therefore the market did not tend to benefit from the cause of this stance. For those buy-siders who were hedge funds that wanted to take short positions in the stock, we have come to understand the company actually interfered in having its scrip out on loan, making it difficult to execute a short position in the stock.

For the sell side, however, whose opinions and views tend to be more publicly available, the actions by the company to counter, mitigate or silence naysayers was more deliberate. Dissenting analysts were either excluded permanently from company events; reported to their seniors (whose companies would be threatened with loss of Steinhoff corporate work) or encouraged to alter their views.

The result of the above was that Steinhoff was able to prevent adverse views on the company from being propagated more openly in the market. What survived was therefore skewed to predominantly positive views. Proof: According to Bloomberg broker forecasts, on 1 November 2017 (a month before Steinhoff’s collapse) of the 11 published broker recommendations, 7 were BUY recommendations and 4 were HOLD recommendations, with NO SELL recommendations at that date.

Questions to pose/ warning signs to look for:

  • How balanced is the range of published recommendations on the stock – is there an excessive number of buys?

  • Does management quieten and dismiss difficult questions in public forums?

  • Is there a record of analysts being excluded from company events; or being pressured for retractions in publishing adverse views on the company

Using hindsight to improve foresight

Given the failure itself cannot be fully reversed, the next best thing that should come out of the Steinhoff fiasco and loss suffered is to ensure we use these costly lessons to identify future problematic investments and avoid or cure them before they result in potentially permanent losses for clients.

While perhaps none of the features we have identified above could have, in isolation, pointed to something specifically untoward in Steinhoff, it’s the messy cocktail of having them all present in one company that significantly heightened its inherent risk.

We concede the very nature of investing has components of risk and uncertainty. Uncertainty we expect in virtually every investment, for it is the nature of assumptions and future expectations. It is risk that we truly want to grasp – most particularly the risk for permanent loss of capital.

When all is said and done, for ultimate savers some of the most important takeaways from the Steinhoff story are that no company is too big to fail; no high profile shareholder is too wealthy to necessarily know better; and no institutional investor is too large or historically successful and trusted to ensure an avoidance of major investment mistakes.

Investing is not simply an endeavour of complex financial models, accurate forecasting and detailed investment analysis but it requires the judgement to discern when and why even the most orchestrated of outcomes, simply doesn’t add up.

We hope the South African investment value chain never has to see an investment failure of the size and extent of Steinhoff again; and we hope in part this will be because we will all actually see it coming.


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