Construction Companies, Fixed Price Contracts and Galliford Try

Stockopedia last week published an article by Roland Head on his SIF Portfolio and the lessons from his biggest losers. He tries to steer clear of stocks that are likely to deliver big losses by a) Diversification by holding an evenly weighed portfolio of 20 stocks; and b) avoiding outliers with high or low P/E ratios, market caps of less than £50 million or those with large price spreads. But over the last three years there have still been seven stocks sold with a net loss of 20% or more, and two more still held that have a running loss of more than 20%.

The interesting aspect is that almost all of them are in sectors that I have developed a prejudice against from past experience and by learning from others. In my forthcoming book I rule out as investments such businesses as drug development companies, miners, oil/gas companies, banks, financial companies, morally dubious businesses, airlines, construction companies and several other sectors. In the SIF portfolio the losers include Plus500 (morally dubious), Easyjet (airline), Banco Santander (bank), Staffline (recruitment), Keller, Costain and Bilby – the last three operate in the construction or building services markets.

You’ll have to wait for an explanation of the others but here is why don’t I like construction companies. They have a great tendency to agree fixed price contracts with customers, or fixed delivery dates with onerous penalty clauses. Another example of the problems in this sector was the profit warning issued by Galliford Try (GFRD) on the 16th April. This company operates in both the housebuilding and construction sectors but have decided to downsize the latter and undertake a strategic review. To quote from the announcement: “The Board anticipates that this review will result in reduced profitability in the current year reflecting a reassessment of positions in legacy and some current contracts and the effect of some recent adverse settlements, as well as the costs of the restructure. The single largest element relates to the Queensferry Crossing joint venture, which has recently increased its estimated final costs on the project”. As usual with this kind of business, it seems that a number of projects are running over budget.

Now one thing I learned from my career as an IT consultant was never to write a fixed price contract for project development because there are always too many uncertainties. Technical problems can arise, the customer keeps changing their minds or delays the project through lack of focus, or resources thought to be available are not. The other difficulty is that the customers are commonly one-off relationships, so they have no motivation to sort out any problems amicably. In reality the customer’s management will always blame the third-party supplier for their own failings.

There are of course ways to write contracts so they look like a fixed price one but are not in reality. Contractors to the defence and rail industries seem pretty adept at this even if they cannot get customer to agree a “cost plus” deal. So for example, it looks like Transport for London, The Government and you and me are going to pick up the tab for the delays to Crossrail – now possibly delayed until 2021 according to the BBC.

One of the other dangers in construction companies is the attractiveness of up-front cash advances on many projects which means they have difficulty turning away future business as their cash flow would then turn negative.

Construction companies of most kinds are ones I have learned to avoid from experience. They may look cheap on the normal financial ratios that investors use, but they are never cheap enough to offset the major risks you run by investing in them.

You may say that with my prejudices I am ruling out as much as half the stock market’s listed companies. Perhaps that is so but that still leaves hundreds of companies to choose from for investment. So why bother with the dubious ones? The excluded companies will still find they get investors willing to buy the stock who like to track the indices and not make decisions about sectors and companies, but more fool them.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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