For many dividend investors, the demise of Carillion was a disaster.
Not only did their portfolios lose an important source of income, they also saw a permanent loss of capital.
As usual, it’s easy to see what went wrong with hindsight, and in the August 2017 issue of Master Investor magazine, I wrote about some of the key lessons from Carillion’s collapse.
But in this case, hindsight was not necessary, and the problems with Carillion were easy to spot even several years before its eventual demise.
Of course, simply saying Carillion’s problems were easy to spot is of no use to anybody, so rather than do yet another Carillion post-mortem, I thought I would apply a little foresight and look for companies with similar “red flags” which investors might want to avoid or get out of.
Who will be the next Carillion?
John — Babcock, Capita?
LR
There are so many to choose from. Capita was certainly on my list, along with Stagecoach and Dignity. I might do another post-disaster write-up for one or more of those.
I find corporate disaster analysis strangely satisfying and very useful. One thing’s for sure, this latest string of avoidable cockups certainly makes me glad to be off the corporate hamster wheel of doom.
Here’s an interesting piece on Dignity (admittedly from a competitor):
https://beyond.life/blog/shorting-dignity-plc-stock/
Interesting article John, I’d venture as far as to say in DTY’s case, it’s a dead business, but that would be trite to say the least wouldn’t it?
On that theme, CVS Group shares some of the same board members, or at least one – their model is similar in that they keep buying up VET practices — I don’t know if they are guilty of the same hiding behind the old name, I suspect not, but maybe price hardening has been a theme — I don’t much favour this model, where you keep buying, I assume expensively, small businesses probably where the owner sees a handy bag of loot to retire on.
I’m sure there will be many more, and CVS may do very well I don’t know.
Needless to say your point is quite valid in that the lessons should be learned with companies like Carillion, Capita, Babcock etc — and the common theme is that they all rely on lobbying government to some degree and probably more importantly the “tendering process”.
I’m out, possibly for ever, outsource and service related companies – unless they have a technological hold of some kind or a patented approach.
Offloaded Britvic before the results and added to WPP on the recent sell off.
LR
CVS Group isn’t on my stock screen as it’s an AIM share, but looking at the data it’s acquisition ratio (acquisitions to post-tax profit) is way over my limit. It’s spent about twice as much on acquisitions in recent years as it’s made in profits, whereas my limit is 100%.
So as you say, the risk is that they’ve built the company on acquisitions, which can be hard to understand as an investor and hard to herd as a manager.
Unsurprisingly, debt has fuelled these acquisitions and the debt level is completely crazy (from my point of view), with borrowings at 10x of recent average post-tax profits (my limit is 4x for most companies).
As for service companies in general, the main one I hold in this context is Mitie. The dividend was briefly suspended but has since been reinstated, so it will be interesting to see how things pan out. In my opinion Mitie has been one of the more sensibly managed support services companies, but that alone may not be enough.
Hi John, Ouch Mitie — I hope in the short term they will benefit from picking up some of the Carillion work fallout — I see Interserve is under close scrutiny by the government.
Mitie has had a pretty long fall over the last couple of years.
I’m working hard to clean up my portfolio at the present and the next on my list to review is De La Rue, which I unfortunately invested in back in 2014, fortunately only modestly — whilst it’s recovered nicely and Sutherland has done a great job of profiling the business, I’m not sure it’s a long term keeper for me despite still being 15% under water — It might have to go if there is no clear path to growth. Selling the paper mills and reducing the debt is a good start though.
LR
“Mitie has had a pretty long fall over the last couple of years” – This sort of thing doesn’t really bother me. First, because each position is sub-5% so any declines are small in absolute terms, and second, I focus on the company rather than the share price and so far (so far!) the long-term prospects for Mitie don’t appear to have changed much (other than perhaps the political risk of a government that wants to nationalise – i.e. un-outsource – everything). But as ever, time will tell…
De La Rue – It ranks quite well on my stock screen, but the total lack of growth over the last decade makes it a no go for me.
“De La Rue – It ranks quite well on my stock screen, but the total lack of growth over the last decade makes it a no go for me.”
That’s something I wasn’t switched on enough in 2014 to have on my check list. Needless to say it is now. I’m in two minds because the company has moved a good portion of it’s business to product authentication, which for high margin product brands, which are prone to being copied, is a growth area. Same goes for electronic security, another area DLAR has been focusing on with recent acquisitions. The Polymer business has more potential and with the offload of the paper mills it’s becoming a little more capital light. Sutherland may have cracked it, but I’ll be pouring back over the numbers this week to see if it’s worth the bother.
I’d like to get my portfolio closer to 30 stocks and it’s still at 38.
LR
Hi, John, I think the nature of the sector should act as a red flag for potential failure. Certain sectors are more prone to failure than others because they either lack pricing power, reduction in volume or increase in cost. These factors can be singular or act in conjunction.
Carillion failed simply because it lacked pricing power and balanced itself on a high volume, therefore, a slight reduction would cause a fall in profit couple that with high fixed costs this was going to end in tears one way or another.
An area that is equally vulnerable to this is the retail sector. This might explain the desperate merger plan by Sainsburys and Walmart’s UK operation ASDA. I think Carpetright, Debenham and Mothercare could potentially claim the honour of being the next Carillion.
Hi Reg, I completely agree. Thin margins and high fixed costs are a recipe for disaster. As for retailers, I haven’t really looked for any basket cases yet. Perhaps I’ll do a “which retail stock is the biggest value trap” article, or something similar.
As for supermarkets, they’re all (including Tesco) in a desperate scramble for scale and volume. Sainsbury failed to get into wholesaling, so ASDA is the next best thing. It’s the next logical phase in the battle against low cost competitors, which at some point is very likely to include Amazon. I think the deal will go ahead, although some store closures are inevitable.
I think the biggest issue with retail sector is its creative destructive nature. The need to continuously re-invent itself puts the investor at the mercy of the management. Without competent management, its extremely unlikely the company will maintain its prosperity.
From the perspective of an individual investor, it’s not very comforting to know this. At the end of the day, a private investor has little influence or sway over the running of a company. For this reason, I try to avoid retail sector.
Companies which are an exception to this are LVMH and Hermes. These companies own extremely valuable intangible assets with products that change very little over time. Therefore even with an incompetent management team, the investor can still depend on the products themselves to take care of the business.
I agree that some companies are relatively immune to the process of creative destruction. However, in those cases the risks do not disappear, they simply shift from corporate risk to valuation risk.
In other words, investors become so convinced that the ‘quality’ company can grow at above average rates essentially forever, that they push the share price up to extreme levels. And if the future turns out to be not quite so rosy as everyone expected (although still perhaps quite rosy) then the total returns can be terrible.
Coca-Cola is the poster child for this risk, with zero capital gains over the last 20 years, despite the company’s continued success. And all because investors became ridiculously optimistic about the company’s growth rate in the late 1990s.
Very true John and I think this reinforces the idea of sticking to your circle of competence as Warren Buffett says. Only through a thorough understanding of a company can you decide whether it is profitable to invest in the stock of a company irrespective of what others advocate. Unfortunately, most people try to skip this form analysis and just view a company through specific sets of financial ratios openly available online now which blinds them to the true nature of the company.