UK-listed companies issued 73 profit warnings in the first quarter of 2018, which was in line with the four-year rolling average. What is more interesting is that the average (median) percentage share price fall associated with these profit warnings is marching up. This rising impact of profit warnings on share prices can likely be associated with higher levels of market volatility as well as the structural nature of the profit warnings, rather than one-offs.
For investors, the higher potential downside of holding a stock that issues a profit warning makes it more important than ever to have a plan in place that can help to mitigate these risks. It would obviously be most ideal if we could avoid profit warnings altogether, but what should we do when we are caught out?
Profit warnings and share price impact
While the number of profit warnings is in line with the four-year rolling average, the median share price fall associated with these profit warnings has been rising.
Source: www.ey.com Ernst & Young Q1 2018 ‘High street blues – Analysis of Profit Warnings’
Spotting the warning signs
Evidence suggests that investors hold on to companies that are performing badly for too long in an effort to avoid crystallising their losses. This can often result in investors holding companies that do not fit their investment criteria and that are also affected by deteriorating sentiment.
The tendency towards loss aversion should be carefully monitored. On average, companies have underperformed their benchmark by around 25% in the six months leading up to a profit warning. An ability to cut your losses could save you a significant amount of pain by avoiding a profit warning.
As well as an underperforming share price, other signals that should be watched include:
- The “kitchen sink” approach, as new management look to disassociate themselves from all bad news;
- Drip feeding bad news, as management avoid the kitchen sink approach to save face (and their pay checks);
- Changing sentiment in management statements, particularly if guidance becomes more downbeat;
- A previous history of over promising and under delivering; and
- High levels of leverage, which could cause problems if interest rates were to rise sharply;
- Is the long term view of the company changed…are the sales still growing? Is the underlying product still popular? Does the warning mean the company can never ever recover its profits?
- Has the warning compromised the long term quality/integrity of the company?
- Has management given clear guidance on the effect on earnings? If yes, then this may be a good(ish) sign.
Furthermore, firms engaging in high-tech operations that have high levels of intangible assets have historically experienced significantly worse negative returns in the face of profit warnings[i] and so these types of firm should offer particularly high potential rewards to justify making an investment.
What to do when disaster strikes
If you missed the warnings signs (which admittedly are much easier to spot with the benefit of hindsight) and you find yourself in the unfortunate position of holding a stock that issues a profit warning, what immediate action should you take? This is the point when rational decisions can prove the hardest, so the ability to tune out the noise using some sort of repeatable process can be extremely beneficial.
“When the facts change, I change my mind. What do you do, Sir?” – Winston Churchill
But should you change your mind? Research based on 445 UK profit warnings by Bulkley et al.[ii] showed that companies issuing a profit warning underperformed the market by 16.6% on the day of the warning, and went on to underperform the market by 4% over the next six months. This would suggest that it is a no brainer to sell as soon as the warning is issued. But there are some other considerations to bear in mind:
Trying to process these questions in the most rational way possible to assess whether a profit warning is a value trap or just a wobble can help you distinguish between the companies that will go on to warn again, such as Carillion, and those that may recover strongly, such as Purplebricks. It’s also worth bearing in mind what the read across might be. Does the warning signal wider industry problems or does it suggest rival strength?
What can I do next?
From six months before the profit warning to one year after it, the average stock lost 41%[iii] of its value. Roughly one third of stocks that warned on profits issued subsequent warnings[iv]. Still tainted with the disappointment of underperformance, these stocks will probably appear very unappealing. However, statistically this is the best time to repurchase those unloved stocks. Between 12 months and 24 months after a profit warning, these stocks on average outperformed the market by 22%[v].
The perfect example of the downward trajectory of a company’s share price in the lead up to, and immediate aftermath of, a profit warning—as well as the subsequent opportunity for gains—can be seen by looking at the performance of retailer Next since the end of 2015. The share price began to struggle in the lead up to Next’s profit warning, and then continued to fall over the next 12 months. However, the recovery over the last 12 months has been significant.
Next plc share price performance
Next’s share price performance over the last three years provides the archetypal example of the response to a profit warning.
Source: Bloomberg as at 07.06.18. Past performance is not a reliable indicator of current and future results.
Of course, not all profit warnings are the same. All the evidence around historical profit warnings shows a considerable amount of variance in outcomes, so it is crucial to judge profit warnings and their possibility on a company by company basis. Nevertheless, having a framework in place can help investors make rational decisions in the heat of the moment.
William Meadon is portfolio manager of the JPMorgan Claverhouse Investment Trust plc within J.P. Morgan Asset Management's UK Equity team. Read more about the Trust >
[i] “Why warn? The impact of profit warnings on shareholder’s equity.” – Fayez Elayan and Kuntara Pukthuanthong, 2009. [ii] “Stock returns following profit warnings: a test of models of behavioural finance.” – Bulkley et al., 2004. [iii] “Stock returns following profit warnings: a test of models of behavioural finance.” – Bulkley et al., 2004 [iv] “Why warn? The impact of profit warnings on shareholder’s equity.” – Fayez Elayan and Kuntara Pukthuanthong, 2009. [v] “Stock returns following profit warnings: a test of models of behavioural finance.” – Bulkley et al., 2004.
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