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Why I’m avoiding these four falling knives

Over the past few years, the investment case for outsourcers has grown thanks to the government’s austerity drive and desire to offload more business to the private sector. However, while there may be plenty of opportunities for outsourcers in the current environment, it does not mean they are sensible investments.

Indeed, the outsourcer model is inherently flawed because these businesses operate with razor-thin profit margins. When bidding on contracts companies usually put in the lowest bid possible to try and win the business, which offloads risk from the seller to the buyer. The combination of these two factors means outsourcers have almost no margin for error when things don’t go to plan.

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And the recent performance of shares in Mitie (LSE: MTO), Interserve (LSE: IRV), Capita (LSE: CPI) and Serco (LSE: SRP) is an excellent example of how investors suffer the fallout from outsourcers’ poor business model.

Falling knives

Over the past 12 months, shares in Capita have plunged by more than 49% as the company has issued multiple profit warnings. Shares in Mitie have fallen 29% over the same period, and shares in Interserve are down by 44%. Serco is the only company to have seen a positive share price performance. Since February last year shares in the group have gained 46%. But to put this into some perspective, over the previous five years the shares were down by a staggering 78%.

Not one of these companies has seen a positive share price performance over the previous five years. The best performer among them has been Capita. Since February 2012 the shares are only down by 15% excluding dividends.

These declines have left Serco, Interserve, Mitie and Capital looking relatively attractive on both a valuation and yield basis but considering the sector’s underlying issues, I’m staying away at all costs.

Value traps

Capita is the perfect example of a company that looks cheap but could be a value trap. The shares trade at a forward P/E and support a dividend yield of 6.1%.

Following the company’s numerous profit warnings, management has decided to sell the business’s asset services division, arguably the group’s crown jewel. Proceeds from the sale will be used to reduce debt and fund the dividend. This could be the first of many sales as the company sells off assets to make up for past mistakes and returns cash to investors.

On a historic basis, shares in Mitie support a dividend yield of over 6%, but after the firm’s recent profit warning, management has cut the payout by 40%. Earnings per share are expected to fall 47% for the year ending 31 March 2017 and not return to last year’s level before the end of the decade. Trading at a forward P/E of 17.5, the shares look overvalued.

Shares in Interserve trade at a forward P/E of 5.3 and yield 10.8% but this lofty dividend might not be around for long. Management warned last week that net debt for 2017 would average £450m, 38% above the group’s current market capitalisation of £326m, a big red flag for investors.

After several rocky years, Serco is struggling to get back on track. City analysts expect the firm to report earnings per share of 3.1p this year, indicating the shares are trading at a forward P/E of 54, a high multiple for a struggling business.

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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.