An important lesson from Carillion plc's 70% share price drop

Construction and support services group Carillion(LSE: CLLN) has featured prominently in the news recently, after announcing a dramatic profit warning on 10 July. The company said a deterioration in cash flows on a number of construction contracts led the board to undertake a review of the group's material contracts, and that the review had resulted in expected contract provisions of £845m. That's equivalent to almost seven times last year's net profit.

The share price was punished hard as a result of the profit warning, falling around 70%, meaning that many shareholders are probably now sitting on significant capital losses. That kind of drop can be hard to recover from.

With that in mind, today I'm looking at whether there were any early warnings signs in relation to the significant share price drop and whether investors could have avoided getting their fingers burnt.

Watch the short sellers

One potential 'trouble' indicator that's always worth monitoring is the list of stocks that are the most 'shorted.' Shorting a stock means that the investor, usually a hedge fund, is betting on the share price of the company falling. So unlike regular 'long' investors, shorters make money when share prices fall. Whereas the market is full of 'weak longs', investors who own stocks merely because everyone else owns them, it's rare to find a 'weak short.'

Indeed, shorters are usually short for a specific reason, and when there's a significant proportion of the market shorting a stock, it suggests that there could potentially be something very wrong with the company.

Looking at the most shorted stocks over the last 18 months, Carillion was consistently at the top of the list. According to this Financial Times article, in April this year 30% of the stock was being shorted, and according to shorttracker.co.uk, even after the 70% share price fall, 21% of the company's shares are still being shorted.

In Carillion's case, investors saw revenues and costs being recorded based on estimates, and trade receivables rising as sales declined. As a result, many bets were placed on the stock falling, and these bets have paid off, with the shorters cleaning up at the expense of the longs.

Other heavily shorted stocks

So what are other stocks being heavily shorted right now? Well, according to shorttracker.co.uk, other popular shorts at present include include names such as Ocado Group, WM Morrison Supermarkets, Tullow Oil and Marks & Spencer Group.

A full list of the top 10 shorts as at the end of the last week is below.

Source: shorttracker.co.uk

Now just because a stock is heavily shorted doesn't necessarily mean it's time to sell up. Indeed, sometimes the shorters get it completely wrong. However, if you are a shareholder of any of the above stocks, my advice would be to try and understand why the shares are being shorted. That way, you can make an informed decision about whether you continue to hold the stock in the face of the institutions betting on the shares to fall.

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Edward Sheldon owns shares in Telit Communications. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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