When I invested in Balfour Beatty in 2011, the company was still performing well despite some obvious headwinds in the UK and US due to recession-like conditions and government spending cuts in both countries.
I thought the company stood a reasonable chance of getting through the slowdown without major problems, and for a couple of years, that was true. However, Balfour gradually became riskier and existing risks, which I hadn’t spotted, began to have a serious impact.
A few days ago I removed Balfour Beatty from both my personal portfolio and the UKVI model portfolio and Balfour has become the first defensive value investment that I’ve sold at a capital loss. Including dividends, it still produced a positive return, but not a particularly good one.
The chart below shows how “eventful” this investment has been over the last three years or so.
So the investment did not work out well which, in and of itself, isn’t the end of the world. Underperforming investments are a fact of life that active stock pickers must learn to live with.
However, it is important to carry out a detailed autopsy of all past investments, especially bad investments. The idea is to extract the right lessons, improve your investment process and avoid making the same mistakes in future.
Buying an established business with a solid track record
In 2011 Balfour appeared to be having an impressive run of success. It had a long-term Growth Rate of 12.1% (for a definition of Growth Rate and the other ratios I use, see the stock screen page and scroll down) and had increased the dividend in every one of those years.
It didn’t have a great deal of debt (just £44m of operational borrowings, which gave it a Debt Ratio of 0.3) and had about half of its business operating on either side of the Atlantic, which seemed to give it some degree of protection from declines in either the US or UK markets.
Here are Balfour Beatty’s financial results up to the 2010 annual report, which was the latest at the time:
The impact of the financial crisis is clearly visible in the company’s post-2007 earnings. However, the general upward trend was maintained with both revenues and dividends apparently unaffected by the recession.
So given that positive picture I added 950 shares to the model portfolio (and a different number to my personal portfolio) on August 9th 2011 at a price of 254p per share. That came to 5.1% of the total portfolio which is a much bigger allocation than I would use today because, in 2011, I was still targeting 20 holdings rather than the 30 I aim for today.
Holding through a bumpy and ultimately disappointing three years
For the first year or so Balfour continued to perform well against a difficult economic environment, but by the third quarter of 2012, things began to change. The company announced that profitability would be below previous expectations and that its construction services unit would face a tough 2013.
The shares dropped by about 20%, although they soon recovered most of that.
2013 continued that less positive trend. In the 2012 annual results, published in March 2013, the CEO spoke mostly of resilience in tough times and of growth when the recovery came, but revenues and profits declined. The full-year dividend was still increased by 2% despite those declines.
In April 2013 the company announced that it was launching an immediate action plan in the face of increasing weakness in UK construction, and further negative announcements were made during the rest of the year.
In 2014 things just got worse. The 2013 annual results were very bad, with underlying profits down by around 30%. This time it was a combination of poor results from both the professional services and construction services businesses, with the key problem continuing to be the decline of the UK construction market.
As is often the case when companies run into significant problems, Balfour turned primarily to cost cutting, disposal of underperforming and non-core businesses, and internal restructuring and refocusing in order to turn the situation around.
In its 2014 Q1 statement, the company announced the CEO’s departure.
It also announced the possible sale of Parsons Brinkerhoff (a professional services consultancy focused on infrastructure), which had only recently been acquired in 2009 for £382m. Parsons was eventually sold in September 2014 for £812m and up to £200m of that was earmarked for a shareholder return.
At the half-year results, the story was the same with the dividend held fast and profits down by more than 50%. By this point the construction services business was solidly loss-making, losing almost £70m at the operating level in the first 6 months of the year.
In September the dividend was put under “review” and the Chairman stated his intention to leave once a new CEO had been found. All in all 2014 was a very bad year.
In 2015 the company found a new CEO (Leo Quinn, previously at QinetiQ) who immediately launched a new transformation program with the goal of reducing costs by £100m and improving cash generation by £200m over 2 years. At that point, the dividend was suspended for two payments, with the expectation that it would be reinstated in March 2016.
Here are Balfour’s most recent results including 2014’s losses:
Selling because of losses, suspended dividends and a potentially difficult turnaround ahead
Generally, I don’t like to sell when a company is still having problems. I prefer to wait for the turnaround to turn, or at least for it to look like it might turn so that I can sell when investor sentiment, and market valuations, are higher.
However, in Balfour’s case, the turnaround is expected to take at least a couple of years, and the share price has remained surprisingly resilient in the face of all this bad news.
The combination of weakening fundamentals and a steady share price has reduced the company’s rank on my stock screen, down to 132 out of 235, which makes it easily the weakest holding in my portfolio. The weak stock rank and potentially lengthy recovery are the main reasons I’ve decided to sell.
Learning the right lessons and applying them to future investments
The final step in the investment process, after buying, holding and selling a company, is to review what happened. The idea is to uncover any valuable lessons that can then be integrated into your investment strategy and applied to all future investments.
This is something I do all the time, and since I invested in Balfour in 2011 I have introduced many improvements to my investment strategy with the twin goals of increasing returns and reducing risk.
These improvements include things like:
- Lowering the amount of debt that I will accept
- Looking at the size of a company’s pension obligations
- Asking questions about how focused the company is and how cyclical it is
- Seeing whether it depends on large contracts
- Measuring how much it spends on capex or acquisitions
- Looking for competitive advantages that are powerful and durable
In relation to Balfour, several of these new checks would have made me more cautious about investing, but one in particular would have ruled it out from the start.
Lesson 1. Be wary of companies that need to repeatedly replace large contracts
This was a lesson I learned a few months ago after Serco (which I also own) ran into serious trouble.
Companies that need to repeatedly replace large projects or contracts carry a lot of risk from either not replacing the contract (which of course would reduce revenues and profits, sometimes dramatically) or bidding too low in order to win a new contract.
If a contract is won at too low a price it can lock the company into wafer-thin profits or even losses over a multi-year period. This has definitely effected Balfour’s UK construction services business.
I’m not totally against investing in these sorts of companies but they should have very low levels of debt; perhaps a Debt Ratio (ratio of current borrowings to 5-year average earnings) of just 3 rather than my usual maximum of 4 for cyclical sector companies.
While debt wasn’t initially a problem for Balfour, it did increase its operational borrowings every year to a high in 2013 of more than £600m (giving it a Debt Ratio of 3.7), which probably was too high.
Lesson 2. Be wary of companies that make lots of large acquisitions
This is another new check that I added to my company analysis checklist in January 2015 and it would have provided another warning flag against Balfour.
My rule of thumb is that if a company spends more on acquisitions in a year than it made in post-tax profits, then that is a “large” acquisition expenditure. The more large acquisitions there are, the more cautious you should be.
In Balfour’s case, it made large acquisitions in the 2007, 2008 and 2009 financial years. In total, it spent some £800m on acquisitions in those years while only making adjusted post-tax profits of £430m.
The problem with acquisitions is that they usually have to be integrated, and the bigger they are the more disruptive they can be. The new CEO has highlighted these acquisitions as a major cause of the company’s current problems.
Although these large acquisitions wouldn’t necessarily have ruled Balfour out as an investment for me, they would have made it more likely.
Lesson 3. Be wary of companies with large defined-benefit pension obligations
Oddly enough pension obligations aren’t something that gets talked about much, but I think they have been instrumental in exacerbating Balfour’s other problems.
The rule of thumb that I brought in a couple of years ago was that a company should have a Pension Ratio of less than 10 (ratio of pension obligations to 5-year average earnings).
I focus on pension obligations rather than whether or not the pension fund is in surplus or deficit because a surplus today can quickly become a deficit tomorrow, so a pension surplus is not a guarantee of safety. Limiting the size of the overall obligations is a better way of limiting any potential deficit funding requirements.
In Balfour’s case, it had pension obligations of £2,795m as at the 2010 annual results compared to 5-year average earnings of £139m. That gave the company a Pension Ratio of 20 which is, quite frankly, massive.
How does that impact the company?
It means Balfour is at risk of running a huge pension deficit which it would have a legal obligation to reduce, by any means necessary.
In fact, in 2010 Balfour’s pension plans did have a deficit of £440m, more than three times its average earnings. That year it had to pay £81m into the pension fund to close the gap, only slightly less than the £84 million paid out to shareholders as a dividend.
Over the last 10 years, Balfour has paid more than £500m into the pension fund and yet it still runs a deficit and the obligations just keep growing (they currently stand at £3,518m).
With the dividend now suspended and £85m of the £200m windfall from Parsons Brinkerhoff going into the pension fund, it seems to me that Balfour is likely to be run primarily in the interests of its enormous pension scheme rather than its shareholders.
That is entirely as it should be, given the company’s legal obligations to the fund’s beneficiaries, but it does illustrate the importance of looking at pension obligations before investing.
Onward and upward
And so my investment in Balfour Beatty is over. It doesn’t join the illustrious ranks of N Brown (50% return in 8 months) or Interserve (117% return in 28 months), but it wasn’t a complete disaster and I did learn some very valuable lessons.
And anyway, it is the long-term performance of the portfolio that really matters, not the results from any one investment.
So now that I’ve sold Balfour I’ll be looking to reinvest the proceeds next month into a better company at a better price, all in pursuit of my long-term investment goals.
Note: You can read the full pre-purchase review of Balfour Beatty in this 2011 blog post (the review was in a blog post rather than the UK Value Investor newsletter because the newsletter didn’t exist in August 2011).