Good afternoon, it's Paul here.

I'm running late again, sorry about that - I appreciate it must be annoying to find only a placeholder post, when you're expecting a full post. I'm on the case now properly, so will update this article this afternoon.


Falling knives

I see that the car crash at Carillion (LON:CLLN) shows no sign of abating. There's been an incredible destruction of shareholder value there, with the share price now down to only 70p (it was 300p in Sep 2016). Therefore it's come into my universe of small caps now.

I really don't know where to start, in terms of assessing Carillion. A quick look at its balance sheet shows that it's dominated by goodwill. Strip that out, and the NTAV is massively negative. So that rules it out for me (before or after the recent profit warning).

Falling knives generally can be a tempting, but easy way to incur losses. I've done a lot of these over the years, so have worked out which ones work, and which ones don't. Basically it's all down to the balance sheet. If a company reports bad news, but has a strong, cash-rich balance sheet, then over time it tends to recover. That stands to reason, because management are not distracted by a fundraising or disposals in order to stay solvent. Instead, they can just get on with fixing whatever issues have caused the profit warning to happen.

So for me, when assessing whether to buy a falling knife, the no.1 consideration is that it must have a strong and stable (!!) balance sheet, with no requirement for any fundraising. Carillion clearly fails that test.

The other key factor for me, is whether the problems which caused a share price to collapse are fixable. If it's just something that's a one-off, ring-fenced problem, then I would consider buying the shares after bad news. If it's a bigger, more serious problem, then I'd steer clear. That's a judgement call, so not something that could be computer modelled.

It would be interesting to revisit Stockopedia's awesome profit warning study, and introduce a balance sheet test. Would that improve the results, I wonder?


Contract companies

Carillion is yet another example of a company dealing with complex, large contracts, has gone disastrously wrong. This happens over & over again…

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