How to avoid another Carillion

It's been a grim day for Carillion staff, subcontractors, pensioners and investors. The once mighty construction company entered compulsory liquidation Monday, leaving thousands of jobs at risk and the shares suspended.

Less than four years ago the shares were worth almost 400p, and cost more than 200p each as recently as June 2017. They closed Friday, just seven months later, at 14.2p.

The firm's death throes were widely covered in the press over the weekend, but Carillion's demise has been a long, drawn-out process. Three profits warnings and a breach of banking covenants reported in November were massive red flags.

A huge debt pile and colossal pension deficit made a rights issue difficult, which meant a debt-for-equity swap would have been the most likely outcome. However, management's inability to secure a resolution with unsympathetic banks has led to this.

Shareholders, it seems, will be left with nothing.

We ran an article in October, with the share price at 48p, explaining how "risk outweighs reward" with Carillion, and then a month later reported how the shares could be worth just 1p.

What to do with Carillion shares

Why Carillion shares are worth just 1p

It's also easy being smart after the event, but there are all sorts of lessons investors can learn from Carillion.

There are books written about investor psychology, but, in short, we all love a bargain.

It's tempting to think that a company has just gone through a bad patch. It's been good in the past, and it will recover again. Sometimes they do - look at ASOS. Its share price rose from nothing to more than £70 in 2014. By the end of the year they were worth less than £20. Now they're back near £70.

Equalling tempting for investors is the dead-cat bounce. Market makers don't always get it right on the first release of bad news, and the price might not be 'right' in the first minutes, or hours of trade. One market maker told me years ago that he'd open the shares 20% lower ona profits warning and see where the buying came in. Trick for investors is to decide whether or not the shares are oversold. This is immensely difficult to get right.

Many companies, even those with big reputations, fail to make that quick recovery following a profits warning. Just look at Provident Financial, Centrica, Saga, the AA, Mothercare and Card Factory.

Warren Buffett famously said: "If you get in a lousy business, get out of it".

How do you know if it's a lousy business? Well, a quality management team is crucial to protecting your capital. Check out the directors on the company website, paying particular attention to their track record. You can quickly spot a weak team.

You can attend the annual general meeting, too, where you'll get the opportunity to quiz top brass.

Profits warnings and how to predict them

Happy with who's running the business? Then, find out if the company has a history of disappointing the market. That might mean persistent delays to contracts.

What's the competition like? If it's a fiercely competitive industry, trouble could be lurking. And that's a big giveaway. If peers are struggling, there's a good chance your company is too.

Check the company's rhetoric, too. If there's trouble brewing, chances are it will have given a heads-up, or at least alluded to issues before the first warning. Look for comments like profits will be "more second-half weighted this year", or profits will be "broadly" in line with expectations.

Alarm bells should start ringing when execs jump ship, or are pushed. Highly-paid chief executive Richard Howson left in July last year, followed by finance director Zafar Khan and a team of managers in September. When the CEO goes, the new one will always try and "kitchen sink it" - getting all the bad news out of the way early in their tenure.

Case study: Marconi

Looking at the financial, see if the company is growing sales. If they are, at least it means people like the product. If margins are decent, it will make good money, too.

Is the company is stretching itself by over-borrowing. Check that the net debt figure doesn't make you wince - net gearing near 100% or higher can be a bad sign. Interest payments can quickly get out of hand, especially as interest rates rise and bank facilities come up for renewal. That's why it's important that the company is generating plenty of cash. If it isn't and it breaches strict covenants, the banks will eventually take over.

Saying goes that profit warnings come in threes, and they really do. Research shows that about three-quarters of companies that announce a profits warning will issue a second.

Companies don't like telling shareholders, let alone the wider public, that things are going badly, it's a fact. It's pride and, in many cases, greed. Successful and highly-paid directors have huge egos, and admitting failure is not in their DNA.

Owning up to problems in the office can mean serious trouble for the businesses. Suppliers will demand cash up front, putting pressure on cash flows, and your bargaining power is compromised if customers get a whiff of something up.

Of course, Carillion's problems could have repercussions elsewhere, specifically among joint venture partners -Galliford Try and Balfour Beatty have already warned of a possible impact from the liquidation.

But, as always, where there is difficulty, there is also opportunity.

"We would continue to buy Balfour Beatty (Rail, Highways), Kier (Highways and Telecoms), Interserve (MoD Infrastructure, Public Sector FM), Serco (Public Sector FM), Mitie (Public and Private FM), Mears (Housing) as these companies are likely to form a key part of client contingency/emergency planning/beneficiaries of market share gain," writes Peel Hunt analyst Andrew Nussey.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.