How to spot a share price collapse before it happens

A profit warning, a decision to cut the dividend to zero and the sudden resignation of the chief executive mean shares in FTSE 250 index member Carillion are trading at 71p compared to more than 190p only a week ago.

To many investors, such carnage seems remarkable when six analysts cover the stock, according to the website www.brokerforecast.com, with only one rating the shares as a ‘buy,’ with four calling it a ‘hold’ and just one a ‘sell.’

Carillion’s shares have collapsed in the past week

Carillion’s shares have collapsed in the past week

Source: Thomson Reuters Datastream

Whether you own Carillion, or have even heard of it, or not, the share price plunge offers invaluable pointers which can help everyone to run their portfolio more effectively, not just by spotting winners but through the discipline of avoiding disasters.

In fact, professional fund managers (a role once held by this author) will tell you that dodging the bombs is more important than picking shares that rise. This is a matter of simple mathematics and can be shown in two ways:

  • At the time of writing, Carillion has lost around 63% of its market value in the past week. To merely recapture ground the shares must rise by 170%. How many shares do you know (or own) that have done that quickly?
  • There is an old market saying: “What is the definition of a stock that has fallen by 90%? One that has fallen by 80% - and then halved again.”

As such, portfolio builders must focus on risk (and downside protection) as much as they do on reward (and income and capital gain accumulation)

Key pointers

The good news is such disasters can be avoided, through diligent research, the application of common sense and a discipline to overcome that most human trait, FOMO (Fear of Missing Out). You may not dodge every bullet – management teams can always do something stupid and in the end unexpected events are what life is all about

Yes, you may miss stocks that do well or offer a fat dividend but they may bring you more risk than you realise (or at least more than you are comfortable with) – and remember that “risk” in an investment context means “permanent loss of capital.”

  1. Listen to the market.

The stock market is not always right but its views always have to be respected. By all means take the opposite view if a share price is going from the top left-hand corner to the bottom right on the chart, but you need to make sure you have a very well-researched reason for doing so.

Carillion’s persistent share price weakness during the year, recorded even as the wider FTSE indices rose, was a potential red flag in itself.

At 192p the shares were trading on a higher dividend yield (9.5%) than they were a price/earnings ratio (5.7x). This was the market’s polite way of saying it didn’t believe the analysts’ forecasts for a second.

  1. If a dividend yield looks too good to be true, it usually is.

Before the profit warning on Monday 10 July, Carillion had been expected to pay an unchanged full-year dividend of 18.45p.

Based on Friday’s closing price of 192p, that equated to a 9.5% dividend yield – a ridiculous figure in the context of the Bank of England’s 0.25%, a ten-year UK Government bond yield of 1.3% or even the 3.8% yield available from the wider UK stock market.

If a bank offered you a 9.5% interest rate on your cash, you would be immediately suspicious and ask why the rate was so generous. In all likelihood, the bank would either be up to no good, in desperate need of attracting cash deposits or both, so the risks would be huge. Again, think of why the rewards are so high and what risks you may be taking to garner them.

  1. Debt is a killer, so look at the balance sheet first, the cash flow statement second and the profit and loss account last.

Carillion ended its last financial year with a net debt pile of £219 million (and that figure averaged £587 million over the year) and a pension deficit of £663 million.

As a result interest payments and pension contributions came to £107 million against an operating profit of £147 million and an annual dividend payment worth £80 million, leaving little margin for operational error.

Sure enough, at the first sign of trouble, Carillion is now scrambling for cash and has abandoned its dividend altogether.

So investors must look at cash flow before profits and also use their imagination: if things look a bit tight, think about what could happen if things go wrong, to ensure they are building in a margin of safety.

Carillion’s precarious finances meant only a minor profits slip would leave the dividend exposed (let alone a big one)

Carillion 2016-17
   
  £ million
Operating profit 145.6
Interest and financial income 14.3
Depreciation and amortisation 45.0
Working capital movement 4.6
Cash in  209.5
   
Capex 37.3
Tax 4.2
Interest payments 60.4
Pension top-up 46.6
Lease payments 0.0
Cash out  148.5
   
Net balance 61.0
Dividend payment  42.0
   
Cover 1.45 x

Source: Company accounts for the year to March 2017

Where the skeletons live

This shows how investors must dig into the balance sheet and cash flow as that is where weaknesses appear first. With all due respect to company finance directors, profits can be presented in a favourable manner (and pages 41 to 45 of Carillion’s full-year results statement from March attempts to do just this). Cash, however, cannot be manipulated or dressed up.

This is not to say debt is bad in all cases. It can be a source of cheap funding (especially in these times of record-low interest rates) and banks currently seem reluctant to pull the rug from borrowers who are struggling to pay their interest.

But investors must make sure the company’s business model is suited to, and capable of bearing, a lot of debt.

Utilities and other industries that have relatively stable demand – like say consumer staples such as alcohol, food and tobacco – can withstand a lot of debt as margins are good and cash flow predictable.

Cyclical areas like paper, pulp, steel and airlines look great when things are going well but can get into trouble very quickly during a downturn if they have a lot of debt.

That “if” is very important. If a company has lots of net cash it should be able to weather almost any downturn, as the available liquidity will cushion the losses.

What you do not want to see is a company that has high financial gearing (lots of debt) combined with operational gearing (whereby a 1% change in sales triggers a much bigger shift in profits).

This example shows why. It is slightly extreme in that it assumes all of the company’s costs are fixed (depreciation, rent, leases and the like) rather than variable (raw materials) but it makes the point.

Note how a mere 5% drop in sales (either through prices or volumes or a combination) means operating profits halve.

Yet the interest on the debt must still be paid and the tax man must be accommodated too.

That means net profits fall faster still and leave the dividend uncovered by profits and potentially exposed to a cut.

How operational gearing works (for good or ill) when it comes to profits and dividends

£ million Base case   Sales fall 5%   Sales rise 5%
           
Sales  3,000   2,850   3,150
Operating costs   (2,700)    (2,700)    (2,700)
Operating profit  300   150   450
Interest expense  (75)    (75)    (75)
Profit before tax  225   75   375
Tax  (56)    (19)    (94)
Tax charge  (25.0%)    (25.0%)    (25.0%)
Net profit 169   56   281
           
Number of shares (million) 16.87   16.87   16.87
Earnings per share (pence) 10.0   3.3   16.7
Dividend per share (pence) 4.0   4.0   4.0
Dividend cover  2.50 x   0.83 x   4.17 x

Source: Michael Cahill, “Making the Right Investment Decisions: How to Analyse Companies and Value Shares”, second edition.

Conclusion

The example does show how gearing can – and will – work the other way when things are going well and the economy is booming, as profits and the dividend can surge.

But investors need to be aware of the dangers posed by any potential slip or economic downturn, especially as history shows the best performing stocks in the long run are those which consistently grow their dividends year by year.

You may not dodge every bullet – management teams can always do something stupid and in the end unexpected events are what life is all about – but the disciplines outlined above can hopefully provide some protection and spare portfolios from some unnecessary pain, by building in a margin of safety.