This week, let's develop something that was merely alluded to last week: Bearbull's law on profit warnings, which states that when a company makes a profit warning it is rarely an isolated event - indeed, the law adds that profit warnings come in threes. This, of course, has important investment implications. For example, health club operator Fitness First issues a profit warning and its share price crumples to a sixth of its 2001 high. Do you rush out and buy the shares? Not according to Bearbull's law you don't. You wait patiently on the sidelines for worse to unfold.
Granted, a law of investment - even one devised by Bearbull - is not like a law of physics. No great surprise there, because investment has a touchy-feely element that the cold precision of physics lacks. Rather, an investment law is a guideline, a touchstone, a point of reference that's hardly as constant as the northern star but which, nevertheless, provides some stability in this troubled world.
And there is no question that the law on profit warnings has some logic to it. What drives it is how business leaders react when things don't turn out the way they want, usually when their soaring aspirations hit that brick wall called reality. In other words, it is about reconciling overconfidence with the guilt and shame that comes with failure. That usually has to be done in stages. It is a rare businessman who can humble himself sufficiently to take the full rap in one blow.
So the first profit warning is prompted by the discovery that things are not going to plan, but is compromised by the residual overconfidence which says that, somehow, things can be pulled round. The brute force of events then necessitates a second warning, which comes closer to the truth but still holds something back. Finally, the full horror can no longer be denied. The boss is fired and in comes a new chief, unencumbered by his predecessor's emotional baggage, who in due course makes the third warning which reveals all and more in one cathartic orgy of big-bath accounting.
Take cider maker HP Bulmer, hardly the most dramatic of this year's profit warnings (that award goes to Cable & Wireless or MyTravel), but a beautifully compact example of Bearbull's law in action. Back in February, Bulmer warned that profits for the year to end-April 2002 would be GBP22m-GBP24m when investment analysts had been expecting GBP30m-plus. The share price duly fell 18 per cent on the month. The second warning came in July when Bulmer said it would post GBP21m for the year, but would also have to take GBP12m of exceptional costs. The share price fell 15 per cent that month. Following further revelations - this time about previously unidentified promotional costs - the chief executive, and then the finance director, quit. This set the stage for the new chief to make the third profit warning in October, in which the board identified further costs of GBP10m-plus, admitted that results for 2002-03 would be far below City forecasts, revealed there would be no dividend and said further write-offs were likely. The share price tumbled further and is now 73 per cent down on the year. It may even get worse. The new chief is only a stop gap and a permanent appointment is expected soon - what shocks might he dish up?
No surprise, therefore, to discover that Bulmer shares won't be going into my speculative fund just yet - certainly not until management shows some sign of reducing the group's burden of debt. Nor, from among those companies that have made high-profile profit warnings recently, will shares in microprocessor designer ARM. This has been on my shares-to-watch list for months, but I wasn't even tempted to buy when its shares fell to a four-year low of 40p, following a warning in early October. Sure, I might discover that the warning was a one-off - it happens - and never see 40p again. Equally, ARM may comply with Bearbull's law. In which case I might have the chance to buy shares in an exceptional company for, say, 20p.
One big temptation on my to-watch list is music industry group Sanctuary, best-known for promoting Dolly Parton and Megadeth. In November, Sanctuary confirmed that results for the year to end-September should be in line with City forecasts of 24 per cent growth in earnings. Not bad, considering the 7 per cent fall in global CD sales in 2002, but maybe not surprising considering that Sanctuary increased its CD sales by 16 per cent. The shares, though still 38 per cent below their 2002 high, are on a bit of a roll lately, which is good, and most likely I will add some to the Bearbull speculative fund before the company reports preliminary results in January. First, however, I need reassurance that the near-doubling of debt to GBP39m during the year, on the back of several small acquisitions, is not a cause for concern.
Mr Bearbull's column has appeared since the 1950s. Its aim is to help readers manage their investment portfolios. It does this by running its own fully-authenticated growth, income and speculative portfolios. E-mail: bearbull@ft.com
