How to avoid lethal stocks

Support-services group Carillion saw its share price collapse last week as the company issued a huge profit warning. Anyone who bought the stock on Friday 7 July and held it is sitting on a paper loss of around 70%. That's very hard to recoup. The share price would need to rise by 230% just to get back to even. Very few stocks recover from that sort of collapse, and certainly not on a timescale that anyone nursing that sort of loss would feel happy about. So how can you avoid this situation in the first place? Here are three red flags that could have alerted investors to Carillion's woes.

Heavy "short" interest: one major red flag was that Carillion was the most shorted stock in the FTSE, and had been for a while (we publish this data on the shares pages once a month in MoneyWeek). Short-sellers make money when share prices fall. However, shorting is highly risky. A share price can only fall to zero, but there is no ceiling on how high it can rise so theoretically, a short-seller's potential losses are unlimited. Short-sellers also need to get their timing right a determined short-seller can stick to their guns for months or even a few years, but it's not a "buy and hold" strategy. So shorting is not done lightly.

If many skilled investors have decided that a company is a worthy short target, then you as a potential investor need to know exactly why that is. Short-sellers don't always get it right and, as with any market, there's the potential for herd behaviour. But you can't be a knee-jerk contrarian about this. If you do decide to invest, you need to be able to explain why you think they're wrong, and why you're right. If you can't do that, don't invest. (See below for more on current short targets.)

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A high dividend yield: Carillion's yield of more than 9% was an obvious red flag, notes Russ Mould, investment director of AJ Bell. If a stock yields nearly 10% in an era of 0% interest rates, that suggests just one thing the market does not believe the dividend will be paid. Again, the market could be wrong but you need to understand why you think that's the case before you even consider buying.

Debt: when used sensibly and efficiently, debt can boost returns. But debt always makes a company riskier for shareholders it means other parties have a prior claim on the company's assets, which means your dividend (or more) is at risk. So you must ensure the company can afford to pay its debts and have money left over for you. As Mould points out, look at the balance sheet, the cash-flow statement, and the profit and loss in that order profits "can be presented in a favourable manner Cash, however, cannot be manipulated or dressed up."

On the short list: steer clear of these four shares

After Carillion , online supermarket Ocado is the most heavily shorted stock in the FTSE, with nearly a fifth of its shares out on loan to short-sellers. The reasons are obvious scepticism remains about Ocado's business model and it's hugely expensive, trading on a price/earnings ratio of more than 150. That said, Ocado has long been one of the most detested stocks on the market, yet it continues to defy the shorts.

Physical supermarkets have been high on the short list for a long time, as online disruption and overcapacity continue to plague the sector. Morrisons with about 17% of its shares on loan may be particularly popular with short-sellers because investors are keen to bet against supermarket real-estate prices Morrisons's stores account for a higher proportion of the value of its balance sheet than either Sainsbury's or Tesco.

Given the crashing oil price, it's no surprise to see an oil-services company John Wood Group in the "most shorted" list. But a more specific issue here is that Wood Group inJune agreed a merger with sector peer Amec Foster Wheeler. The latter has now been swept up in the Serious Fraud Office investigation into Monaco-based energy consultancy Unaoil (which has also hit rival Petrofac hard).

Hefty debts combined with the plunging oil price forced Africa-focused oil explorer Tullow Oil to raise $750m via a rights issue earlier this year, while the company had to take a $600m hit on the value of its property and equipment at its half-year results last month. Debt has started to fall, but it still stands at $3.8bn. The company's fortunes remain tied to the oil price, which may explain the short interest of nearly 14%.