What investors can learn from Carillion’s collapse

So that's it for Carillion.

The support services giant had been hoping for a last-ditch bailout from the government. But it would appear that the government made the sensible choice and realised that yet another "too-big-to-fail" company would be a major electoral liability, which is the last thing it needs right now.

This morning, the company has announced that it has gone into liquidation.

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So what's next? And can investors learn any lessons from this debacle?

The collapse of Carillion

Carillion's fate is not exactly a surprise. It issued three profit warnings in just five months last year. Now its banks have pulled the plug, and the government has decided not to bail it out.

But it is painful for its tens of thousands of employees and subcontractors, who will now face an extended period of uncertainty. It's embarrassing for the government. And it also means that shareholders are wiped out.

So what went wrong? The construction and support services giant's business was based on constructing and then maintaining buildings for the public sector. These projects operate on very thin profit margins, so if anything goes wrong, the profitability is easily wiped out.

Carillion also loved its acquisitions. As a result, it had also built up a huge debt pile nearly £1bn, not including its pension deficit of nearly £600m and it couldn't generate the cashflow to cover it.

In short, the company dug a deep hole for itself and now the sides have collapsed.

As for what happens now, in effect, Carillion has been temporarily nationalised. The plan is a "managed liquidation and administration", as one cabinet office minister put it on the Today programme this morning.

Staff will go to work as normal, they will be paid by the government via the Official Receiver, and in time the various contracts will be taken over by other companies (many of them partners of Carillion). The Pension Protection Fund will take over the Carillion pension fund (so staff won't lose their pensions).

The lessons you can learn from Carillion

It'll take a while to process the full fallout from all of this. The biggest immediate issue is likely to be for small subcontractors who as always will be hit hardest by inevitable payment delays.

Longer term, any contracts Carillion is involved in will presumably have to be re-tendered out elsewhere, or taken over by the public sector, which in all, is likely to mean more expense for the taxpayer (although that's not something any of us will notice immediately).

And of course, investors are wiped out. And as we're all about the investment here, let's look at some of the key lessons investors can draw from this.

Firstly, make sure you understand what a company does and where it makes its money. If you own a share, then why do you own it? What's the rationale? How do you justify its place in your portfolio?

Carillion was a complicated company, with a lot of moving parts. Lots of long-term contracts and regular acquisitions make it easier for accountants to find places to hide the less flattering parts of the business in entirely legal ways. Are you really skilled enough a forensic accountant to unpick all that?

Or should you just take a heuristic shortcut, and remember that aggressive acquisitions often suggest that a company is struggling to generate growth in the traditional ways?

Secondly, always remember that a share price that has halved can half again and keep on halving until it gets all the way to zero (note to pedants don't get all "Zeno's paradox" on me). They say that profit warnings come in threes and, sadly, they're often right. The first profit warning is rarely the last, because corporate managements do not relish telling their shareholders that things have gone wrong. So the first profit warning however bad is usually an understatement of just how pear-shaped things have gone.

Thirdly and relatedly the market isn't perfectly efficient, but it gets things roughly right more often than not. The market correctly treated Carillion with a lot of scepticism, even before the profit warnings. The unusually high dividend yield wasn't a sign of a bargain it was a sign that it was on borrowed time.

So if you're going to bet against it, you have to have a good case for doing so. It can't just be on a hunch, or because you've seen the share price fall a lot and so reckon it should probably bounce back.

In particular, as I mentioned around the time of the July profit warning, it pays to keep an eye on short sellers. Carillion has been a popular short-selling target for at least two years now. Short selling is an extremely risky way to make a living, that requires both high-conviction and nerves of steel. So you have to assume that short-sellers work harder than most people who are "long".

As a result, if you are betting against them, then at a minimum, you should be able to articulate their case, and then be able to argue convincingly why they are wrong. We publish a list of the most-shorted shares in the FTSE in MoneyWeek once a month (if you're not already a subscriber, get your first four issues free here).

In short, Carillion was one of those stocks where the red flags were in plentiful supply. If you owned it and you're staring down a 100% loss right now, then you have my sympathies (we've all been there).

But to salvage something valuable from this, take a look at your investment process. Try to work out how it ended up in your portfolio in the first place, and why it stayed there even after the stream of profit warnings. It won't be comfortable, but taking the time to do it will pay off in the long run.