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1 painful lesson I learned from buying Slater & Gordon Limited shares

The Slater & Gordon Limited (ASX: SGH) share price is extremely volatile today, but a wall of dilution could be headed its way.

SGH Share Price

Source: Google Finance

Source: Google Finance

As you can see from the graph, it’s been a wild — and painful — ride for many Slater & Gordon shareholders.

Last week, Australia’s once-largest law firm said the new owners of its debt would be pursuing a deal to restructure its debt, potentially in a debt-for-equity swap.

That means the $700 million in debt currently on the company’s balance sheet could be turned into new shares. While that would keep the company alive it would mean that current or existing shareholders would have their ownership massively diluted.

My Painful Lesson Buying Slater & Gordon Shares

A few years ago, I bought Slater & Gordon shares. I invested at a relatively low share price and thought I was onto a good thing when the share price started rallying. The company appeared to be making use of a successful growth model, buying smaller firms and slapping the Slater & Gordon brand on law firms right across Australia.

In January 2014, I wrote that despite a 12-month share price rally the company had more potential, especially in the UK.

A year later — having bought a stake in Slater & Gordon for my family’s portfolio — Slater & Gordon announced its $1.2 billion acquisition of Quindell Plc’s professional services division. Quindell Plc is a UK company with a very poor track record. The deal was big, far bigger than anything Slater & Gordon had undertaken before.

At the time, still holding its shares, I wrote:

“This is a landmark deal for Slater & Gordon and its most brazen. Whilst the firm said it has reviewed 8,000 case files whilst conducting its due diligence, a number of teething issues could result from such a large acquisition over time.

Indeed, despite Slater & Gordon confirming its 2015 financial year revenue and cash flow guidance, investors should remain cautiously optimistic about the deal.

As always, before committing to take up of your offer for new shares, it’s important to maintain prudent levels of diversification within your portfolio and refrain from being heavily exposed to any one sector or company.”

Eight days later, having said I would take part in the offer to buy new shares (which were being issued to fund the acquisition) if they remained below market prices, I wrote:

“looking ahead into the near future, I’ll likely start to take a large portion of my paper profits off the table and reduce my exposure. Whilst the potentially significant upside from the PSD acquisition could be realised sooner rather than later, I think Slater & Gordon’s valuation has become somewhat stretched given the uncertainty looking ahead.”

Regrettably, I was slow to take my own advice. It cost me and my family a bucket load of cash.

1 Lesson

I knew that Slater & Gordon had ‘bad economics’ and that aggressive acquisitions could come back to bite it, yet I still invested in its shares. What I mean by ‘bad economics’ is, does a law firm become more profitable for buying other law firms? Revenue from the new lawyers goes up, sure. But so does wages, office costs and marketing.

Some value will be generated of course, but if Slater and Gordon’s management misjudged an acquisition and paid slightly too much for a company, the value of buying the business would be eaten up. My fears came true.

In addition, Slater & Gordon used some dubious accounting rules to make it look like profits were flying higher. However, cash flow did not keep pace with the reported profits. It was a mistake not to pay closer attention to the trend. 

Foolish Takeaway

My number-one learning from buying and holding Slater & Gordon is that it was fundamentally a bad investment. It used takeovers to make its numbers look impressive, even when they weren’t. It had bad economics.

Looking ahead, I’m very reluctant to buy into similar businesses and growth models. In my opinion, companies like G8 Education Ltd (ASX: GEM) and Estia Health Ltd (ASX: EHE) are other businesses that have poor economics. Investors should be wary of overpaying for them.

Going one step further, I believe there’s no need to invest your money in companies like Slater and Gordon at all because there are over 2,000 other shares listed on the ASX — you can afford to be picky.

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Motley Fool Contributor Owen Raszkiewicz does not have a financial interest in any company mentioned. Owen welcomes and encourages your feedback. You can follow him on Twitter @OwenRask.

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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