Profit warnings: what to do

A profit warning is a bit like opening Pandora's box. The minute a company warns the market that it will not be able to meet consensus expectations, all hell breaks loose, leading in most cases to a swift correction in its share price. And by the time small investors hear the news and contact their broker, the damage is already in the price.

Quite often, profit warnings are followed by a second, a third and sometimes a fourth warning. And even when the warning is a one-off, the disappointment always leaves a stain on the management's reputation which can potentially cap the share upside for the years to come.

Lately, listed companies have brought UK investors their fair share of misery. In fact, the number of profit warning reached its highest level since 2001 in the last quarter of 2007, according to consultancy group Ernst & Young, and the first quarter of 2008 was equally bad, as the period saw a multiplication of profit warnings in the retail, banking, property and travel sectors. Since then the pace has eased a bit, largely becasue analysts have lowered their forecasts across the board. But earnings are now under serious pressure as the risk grows that the UK will enter a recession. Investors should therefore brace themselves for a wave of profit warnings over the coming months.

What should you do when a warning strikes?

Against a backdrop of falling share prices and an economy under pressure, the best strategy is obviously to avoid the sectors at risks, and companies with a long history of announcing profit warnings, and shift instead towards companies that offer high visibility on their earnings. But with tough times ahead, this is certainly easier said than done and in any event it's sensible to plan ahead for a profit warning event.

Investors faced with a profit warning have to make a decision: to sell at a loss or wait for a rebound. If you don't already hold the shares, you should be asking yourself the question: does the depressed share price offer an entry point into the company?

The answers, however, are far from black and white. The appropriate reaction to a profit warning depends on a number of variables, such as the severity of the profit warning, the reaction of the market, the company's strategy, its competitive position and the dynamics of the sector. The market cap and liquidity of the shares also have a role to play. But it also largely depends on your aversion to risk.

What do fund managers do?

Some fund managers automatically cut their position when a company issues a profit warning. That's often the case of the case with managers of income funds. But dynamic yet cautious investors like Mark Westwood, who runs the Threadneedle UK Select Growth Fund, also consider this a good housekeeping rule. "In the first place, we avoid companies which provide limited visibility on their earnings to limit these unpleasant surprises as much as possible. But when we are confronted with a profit warning, we sell the share as soon as we can," he says.

Mr Westwood argues that the last thing a company wants to tell its shareholders is that it is not trading well. So if the management is forced to do so, investors can, for once, take their word for it. What's more, the profit warning is often just the tip of the iceberg. "In fact, 75 per cent of the companies which have a profit warning issue at least another one," he says. "And on a second warning, the share price is likely to fall dramatically again. In practise, this means that not only has the bad news not been reflected in the share price entirely, but also that the chances that it will bounce back are statistically slim."

Consequently, Mr Westwood prefers to sell the share and recycle the money into companies on which he has stronger convictions. "Some investors hold on to their losses in the hope that the company will turn itself around. But structural changes take a long time to deliver. So I'd much rather cut that position on the first profit warning and reassess the company after a third or a fourth profit warning," he argues.

Other fund managers, however, take a more opportunistic approach and prefer to assess profit warnings on a case by case basis. "The worst of the correction happens within the first hour of trading and the risk in such a short timeframe is to succumb to panic and sell your best investment ideas in a rush," says Andy Brough, a fund manager at Schroders. "I believe that it makes more sense to step back and try to figure out calmly whether or not the business model of the company is broken. If so, I won’t hesitate to cut my position within the next few days. Otherwise, I will brace myself for patience."

But there are also contrarian fund managers for whom a profit warning provides an entry point into a share. "The aim of a contrarian investor is to exploit the irrationality of the market. As such, profit warnings often provide us some interesting opportunities as the market tends to over-react and overlook the companies' long term prospects," says Alastair Mundy, head of the UK contrarian team at Investec Asset Management."

But Mr Mundy points out that while he might keep the share in his radar screen, he "won't jump on the first profit warning", as its price often has a long way to go before it can offer a decent risk to reward ratio. That's because contrarian investing is a tricky strategy and investors have to make sure that they don't catch a falling knife. Like the opportunistic investors, Mr Mundy assesses the companies' long term prospects on a case by case basis.

To see how these different strategies work in practise, we've tracked the performance of companies issuing the most significant profit warnings in the last quarter of 2007 and the last quarter of 2006.

Proceed with caution

Unsurprisingly, the short term performance figures back up the cautious investors. All but one of the companies were trading well below pre-profit warning price and some issued further profit warnings in the following months. That's the case notably with Rentokil Initial, the FTSE 100 largest support services group. In December, the company, known for its historic pest control business, flagged difficulties at City Link, its parcel delivery division, and warned that fourth quarter earnings would be £10m below expectations. Back then, the group blamed a softening in corporate demand. But on 28 February, the group had to warn the market again over its 2008 profits and admit that City Link's poor performance was also due to management issues and poor integration of acquisitions. That day, the share price dropped a further 23 per cent. In April the company delivered a third blow but this time it softened it by also announcing substantial changes in the management structure. The share price barely moved on the day and seems to have found a floor since. Rentokil therefore appears to confirm the view that the bad news is never entirely priced in on the first profit warning.

In Rentokil's case, the performance on a longer term basis also backed up the view that it is wiser to sell a share immediately after a profit warning. Indeed, most of the shares tracked were still largely down one year on.

The most dramatic underperformance came from Fishworks, a small seafood restaurant chain quoted on the Alternative Investment Market. Its steep correction is partly down to the sector's poor reputation for creating value for shareholders, but also to the fact that profit warnings often have a drastic impact on small and micro caps. In practise, this means that investors who fail to sell immediately after the profit warning can face a long period of underperformance with these illiquid shares.

But this example also proves the cautious investors' point that it takes a long time to turn around a business. Back in November 2006, the company justified its profit warning by saying that its unsuccessful fish bar located in the Harvey Nichols department store had distracted the management from its initial objective which was to open 19 restaurants by the July 2008 in affluent areas of London. Since then, however, losses have trebled and the group was forced to close one of its most prominent restaurants in Notting Hill.

While most of the shares tracked are still significantly down both in the short and longer run, there are nonetheless a few significant exceptions that support the opportunistic investors' views. In the short term, suit retailer Moss Bros was trading 22 per cent above its 5 December profit warning price by the end of February. That's because just a few days after the waring rumours spread that Icelandic investment vehicle Baugur would quickly seize the opportunity to make an offer for the company. This soon materialised with a 42p bid but the move was fiercely opposed by members of the founding family, who refused to see the retailer go on the "super cheap". The family held talks with other investors to make a higher offer. In May, Baugur withdrew its offer, wiping off most of the gains since the profit warning.

Another exception is sports apparel group Umbro which issued profit warnings both in 2006 and 2007. Over one year, its shares rose back well above its pre-profit warning price as the depressed price provided American firm Nike with an opportunity to snap up its competitor. In a similar move, record label Sanctuary returned an impressive 196 per cent from its profit warning price following its acquisition by Universal Music Group.

Clearly this shows that investors can expect solid returns if a takeover bid emerges. But holding on to a share in the hope that a competitor or a private equity firm will come to the rescue is a difficult game however. Offers can take a long time to emerge, and even then it might not mature into a real bid. How do you decide whether or not it's worth keeping the share? Investors have to look at clear indicators such as the capital structure which indicates whether or not the company can easily be taken over. Check to see if a shareholder has been actively building a stake. Other indicators are the quality of the assets, in particular intangibles such as a patent or a brand. The Sanctuary group had unique intellectual property assets with a catalogue of over 80 artists under contracts that had the potential to whet interest its competitors' appetites at a time when the industry needed to consolidate.

In the last quarter of 2007 restaurant chain Clapham House issued a profit warning. This company - until then considered as a rising star of the sector - took the market by surprise when it issued a profit warning only two days before releasing its results. It led to a sharp correction in the share which closed 40 per cent lower on the day. Yet by the end of January, the share price was trading only 10 per cent below its pre-profit warning level on the news that Capricorn Venture International had built a 24.9 per cent stake in the company. The move immediately fuelled speculation that the restaurateur could be taken over as this Belgian private equity firm had already bought Pizza Express and Ask in similar circumstances.

Back in December, investors could reasonably have believed that the group would attract interests after its profit warning. The company was small enough to be swallowed, and it was in a sector where private equity firms had been active during the last few years. What's more, Clapham House owned a strong franchise with its Gourmet Burger Kitchen chain, even if its Tootsies family-themed restaurants were struggling. But while Clapham House ticked the right boxes, for potetinal buyers raising capital to finance an acquisition has become increasingly harder. Investors waiting for an offer to materialise are therefore taking a gamble. If you've got a limited appetite for risk, you should use the speculation to minimise your losses and exit the share.

Finally, it is worth noting that the profit warnings tracked provided a few entry points on contrarian bets. Fund manager Alistair Mundy notably bought shares in companies such as Woolworth and HMV in 2006 and increased his holding in jewellery retailer Signet in 2007. "In my view, the market has over-reacted to the company's exposure to the dollar and weaker consumer spending in the UK," he says. "But with a three to five years view, the share appeared deeply undervalued. Signet continues to gain market share and in the long run this higher scale will enhance its profitability and pricing power."

But like most contrarian investors, Alastair Mundy is prepared to face a sustained period of underperformance on these shares before this strategy delivers. Arguably, some personal investors with a large appetite for risk might be willing to take that bumpy contrarian route. But those investors have to bear in mind that fund managers have well-diversified portfolios that help to spread the risks.

So, contrarian buying is best implemented in a well diversified portoflio, and it's sensible too to purchase a small holding in the share which can be strengthened gradually as the company shows signs of recovery.

Then, investors need to track the company's fundamentals. Of course, this can prove tricky shortly after a profit warning. To assess the company properly, investors can use some of the metrics frequently applied by contrarian fund managers. One popular ratio is the Enterprise value to sale, which measures how much it costs to buy the company's sales and, as such, gives a projection on the company's margins growth potential when it cannot be properly valued on depressed profitability levels. Margins are also closely tracked to make sure that level of profitability has not been distorted by short term factors.

Finally, investors must ensure that the share price is cheap enough to offer a decent reward for the risks taken. One of the contrarian fund managers' favourite ratio to measure this is the Price to Book, which measures the price relative to the company's equity. This gives a good idea of how much the company is worth if it goes bankrupt and reflects the level of mistrust towards the company in the market.

Why we should worry

In its latest quarterly survey, Ernst & Young recorded 114 profit warnings from UK listed companies during the first three months of 2008. This equates to an 11 per cent increase on the first quarter of 2007. Worryingly, the number of profit warnings was above the 100 mark for the second quarter in row. "The last time UK Plc issued more than 100 profit warnings in consecutive quarters was in 2001, when the technology-led boom meant painful readjustment. The hangover from the credit-boom could be equally severe," wrote the consultancy group.

Ernst & Young also noticed a steep rise in the number of main market companies, in particular in the FTSE 250, which are now demonstrating greater vulnerability to the current economic environment. And investors were also more nervous than usual. On average, profit warners suffered a record-breaking 19.3 per cent fall in the share price on the day of the warning against an average of 15.1 per cent during the last four years.

During the first quarter, the worst offenders were general retailers, support services and software and computer services. The number of profit warning also rose dramatically in financials, with 17 profit warnings, or its highest recorded level in a single quarter. The Ernst & Young report however pointed out that the proportion of level appeared low given the size of the industry, "suggesting that many companies are meeting or at least managing expectations".