2) Be wary of companies whose history is littered with acquisitions
Merger and acquisition (M&A) activity brings complexity too, as deals must be integrated staff kept happy and motivated and customer service maintained.
M&A tends to work best when small, bolt-on deals are used to supplement existing momentum (as is the case at Halma and Bunzl) not create it. Carillion acquired Mowlem in 2006, Alfred McAlpine in 2008 Eaga in 2011 and John Laing’s facilities management business in 2014 before a failed lunge for Balfour Beatty in 2014.
These deals expanded the company’s range of services and geographical reach – to bring complexity into the company and take some cash out of it.
3) Debt can be deadly if profit margins are thin
Debt in its own right is not inherently bad (despite the Shakespearean warning in Hamlet about “neither a borrower nor a lender be, for loan oft loses both itself and friend”) as it can be a cheap and ready source of funding.
However, the company’s business model must be suitable – and that means demand must be fairly predictable and margins consistent (and preferably fairly high) so that the interest can be paid without difficulty and interest cover is good.
Utilities and tobacco stocks can take on a lot of debt pretty comfortably.
Tech stocks tend to avoid it, as they need to keep investing in research so their fixed costs are high, and construction firms tend to avoid debt, too, to ensure they have a nice cash buffer in case a big project goes wrong and they are hit by cost over-runs.
Carillion did not take this precaution and it was further hobbled by a huge pension deficit with disastrous consequences. In 2016, it generated a stated operating profit of £146m on sales of £4.4bn for a margin of just 3.3 per cent - and that operating profit had to fund £60m of interest and pension payments, tax and £79.8m in dividends so there was little margin for error.
4) Always look at how management is incentivised to behave
As Charlie Munger, vice-chairman of Berkshire Hathaway once said: “Show me the incentive and I will show you the outcome” and questions can be asked about how bonuses and options were triggered for senior executive directors at Carillion.
In 2016, former chief executive Richard Howson received a £245,000 bonus and £346,000 in long-term performance incentives which helped to take his total package to £1.5m.
In principle, the structure of the bonus mechanism seems sensible enough, as it was 30 per cent based on earnings per share, 20 per cent on cash conversion, 25 per cent on operational performance indicators and 25 per cent on internal leadership and staff engagement ratings.
