The liquidation of construction services business Carillion (CLLN) is dominating the front pages and we discuss the fall-out in more depth in this week’s Big News section of Shares.

Clearly there are lessons to be learned about having private companies whose operations are so large and entwined with public services that they become ‘too big to fail’, but there are also important takeaways for investors.

Among the most important is to avoid companies which are pursuing growth for its own sake, something US writer Edward Abbey described as the ‘philosophy of the cancer cell’.

Carillion took on too many big jobs at the wrong price and operational issues saw costs on many of these projects over-run.

In 2016 its underlying operating margin for its UK-dominated construction services division fell from 3% to 2.7%. Put this weak profitability together with substantial liabilities in the form of mounting net debt and a big pension deficit and you had a toxic mix.

Compare the sorry mess at Carillion with the recovery story currently underway at Bovis Homes (BVS). Amid a series of recent trading updates from the sector the company got the most positive response despite the volume of new builds falling in 2017 from 3,977 to 3,645.

Crucially, though, these homes were in its own words ‘delivered in a controlled and disciplined manner’ under new chief executive and industry veteran Greg Fitzgerald after the company got into difficulties over the quality of its homes in 2016.

REVENUE GROWTH NEEDS TO TRANSLATE INTO PROFIT AND CASH FLOW

This ‘quality over quantity’ approach is ultimately what you should be seeking from most prospective investments. After all, what is the point of delivering growth if it is not as some stage going to translate into profit and cash flow?

• Is earnings growth matching revenue? If not, why not? Early stage companies may fail this test as they invest for future growth and this is why investments in such companies are higher risk. However, if a more mature company is becoming less profitable over time you need to ask serious questions.

• If there is earnings growth, is it backed by
cash flow? Earnings per share can be massaged higher through clever accounting, at least in the short-term, but cash flow typically offers greater clarity on how a business is performing.

• How are management incentivised? Bonus schemes predicated on increases in earnings per share can be a warning sign.

• How strong is the balance sheet? If a company has historically high levels of borrowings is it capable of servicing these and ultimately paying them down over time? (TS)

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