Russ Mould, investment director at AJ Bell, comments:
"The monster profit warning and a decision to cancel all dividend payments from Carillion will delight hedge funds, as the support services firm is the single most shorted stock on the UK market and the shares are down by a third in early trading.
"The plunge follows Carillion’s announcement of a revenue shortfall, lower-than-expected gains from the sale of Private Public Partnership (PPP) contracts and £845 million in provisions to cover problematic contracts in the UK and a withdrawal from the Middle East and Canada.
"The spectacular collapse offers three particularly useful lessons to investors.
If a dividend yield looks too good to be true, it usually is. Before today’s alert, 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.
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, the company is scrambling for cash and has abandoned its dividend altogether.
The stock market is not always right but its views always have to be respected. 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 (5.7), which was the market’s polite way of saying it didn’t believe the analysts’ forecasts for a second.
"The sceptics have now been proven correct to the particular delight of the hedge funds that had shorted the stock, including Marshall Wace, Thunderbird Partners and Immersion Capital, as they will be reaping substantial gains from their bearish views.
How “shorting” works
"Hedge funds short a stock by borrowing shares they do not own from another fund manager, in return for a fee (they also cover any dividends that the actual shareholder loses during the loan period).
"The hedge fund then sells the shares in the view that they will go down. If their research proves correct and the shares fall, then the hedge fund buys the shares back at a price lower than where they sold them, to lock in a profit and then return them to the original owner.
"It is this process of closing out (and buying the shares back) which helped to explain why Carillion opened up down by nearly 40% and then began to rally to being down by “only” a third.
"Shorting is a risky strategy especially as stock markets tend to rise over time and there is no upside limit to a share price, so the losses can be huge if a shorted stock starts to go higher (especially as this often creates a “short squeeze”, whereby hedge funds hit their stop loss on a position and have to buy the stock back, pushing the shares higher still and inflicting more pain on fellow short sellers).
Where to find data on shorted stocks
"Anyone going short of a stock must declare their position if they are borrowing more than 0.5% of the shares in a company, or there are any changes in their short position above this threshold.
"There is no disclosure required if the short position is smaller than this."
The Financial Conduct Authority compiles a daily log of this data, which is then analysed by the helpful website www.shorttracker.co.uk.