Profit warnings are the single most nail-biting anxiety for investors in individual shares. And for good reason. Investors typically lose 10-20 per cent of the value of their investment on the day when a company warns, according to Ernst & Young (E&Y). Its research shows there are typically 200 to 300 warnings a year among UK-listed companies.
That's well down from the 449 issued in 2008, but with 5 per cent of quoted companies warning each quarter, the average small investor with, say, 20 stocks in a portfolio is likely to suffer four a year. That's four nail-biting decisions to be made, often in the absence of clear information.
Between the release of a regulatory news item at 7am and an investor's first real chance to trade after 8am, that could means thousands of pounds lost, perhaps tens or hundreds of millions lost in the company's overall value. So is there any way we can anticipate profit warning? Are there preparations that we can make?
Of course, not all share price falls are driven by formal profit warnings. There are all manner of unexpected news that can drive a share price lower, just as there are others that will drive them higher. The same techniques can be used for all, and really it's quite simple. Know the types of risks we are running, prepare in advance to deal with them, and have a definite plan ready to execute.
Knowing the risks is actually an integral part of knowing the characteristics of the shares we own, an evaluation process that should be made before we buy.
Pick the industry carefully
Some companies are hostages to the winds of fortune by virtue of what they do. 'Externalities', as economists call them, are any factors beyond a company's control. And some have far more impact than others. Most airlines and holiday companies, for example, operate not only in highly competitive sectors, but are affected by all sorts of externalities, from Icelandic volcanoes to health scares such as Sars, and from air crashes through to political turmoil in destination countries. Many of these shares may be cheap (though not all) but this is often for a good reason.
Know the right cycle
This isn't just a question of sensitivity to the economic cycle. Some shares are cyclical, and there are early movers and late movers within them. But there are other cycles, too. Take mining, for example. The so-called supercycle based on Chinese growth followed the trend of broader indices in the global financial crisis, but has recently dropped even as western economic recovery begin. There were six warnings by FTSE miners in the first quarter, which E&Y says was a 13-year record. Regulated utilities have their own cycle, five-year pricing and capital spending regimes which lead up to important decisions that can affect their profitability for years to come. Understanding the cycle, and what stage of it the company is in, is an important part of preparation for those key moments when profit risks are highest.
How visible are earnings?
Visibility of earnings is a great protection against profit warnings. Those rare companies that can boast that they already have 90 per cent of this year's earnings in the bag, and 75 per cent of next year's offer some security. But expect to pay handsomely for this visibility. The largest outsourcing companies - Capita and Serco, for example - have done this for years. They not only have long-term contracts, but many of them. The win or loss of any one deal is unlikely to make too big a dent on expected revenues. They are still vulnerable to long-term shifts, such as the climate for public sector outsourcing, but this is rarely an overnight change. Nevertheless, in the first quarter of 2013, the FTSE Support Services and Software & Computer Services sectors issued the most profit warnings.
Monitor the spread of customers
The bigger the spread of customers a company has, the better insulated it should be against a profit warning. Dairy companies and pork producers whose main customers are one or two supermarkets are not only squeezed on margin, they have a lot riding on a single buyer's whims, too. Having lots of customers is better - so long as those customers' purchases are not too closely correlated with each other. An engineering contractor, for example, servicing rig-building markets in the Middle East, Chinese power station construction, and Korean shipbuilding is exposed to three separate cycles. One that only services rig builders, however geographically spread they may be, is still making a clear bet on oil.
Analyse a company's engine room
The vital signs of company health are not too dissimilar to that of a person. Carrying an excessive debt load makes a company overweight, and unwieldy, unable to respond rapidly to crisis or opportunity. Once you read talk about banking covenants, you know that company is sailing close to the wind. That doesn't in itself make a company a dog. A number of pub companies, for example, are little more than a play on a schedule of debt paydown, and can be heavily operationally geared to small changes in circumstances. That's fine, so long as the investor knows that is what they are there for.
Watch cash flow
Closely related to debt, cash-flow problems are the cardiac arrest of corporate life. Far more companies have gone to the wall through having cash-flow problems than by being intrinsically unprofitable. Start-ups dependent on funding, construction companies waiting to be paid by bigger clients, particularly those in the UK public sector and abroad, are all vulnerable. But cash flow is a vital pulse for all companies which should be taken before buying any share. One quick sign of reliable cash flow may be a steady dividend payment record.
Keep an eye on operational gearing
A company's profit sensitivity to small changes in revenue is one of the prime drivers of beta - a share's measure of volatility relative to the market or benchmark. This may not tell you how likely a profit warning is, but it should be a clear hint of the share price reaction should one occur. More generally, beta tells you the day-to-day sensitivity of a stock to both market sentiment and company-specific news. Small companies trading in thin markets, or even thinly-traded debt issues as we've seen with the Co-operative, can exhibit startling price movements.
Gauge how far the share might fall
In most cases, all the points above are baked into the price. The market prices for the risks it can see. For companies that have delighted investors, the penalty for failure may be huge. For serial profit-warning offenders, where expectations are already low, it may not be (unless survival is at stake).
Take the shooting star that is internet retailer ASOS. Few would deny the glorious success that the company has become, constantly exceeding expectations to become a global force in online fashion retail. However, the shares trade at such an exalted multiple of earnings, that even if ASOS decided to pay every penny out in dividends, it would take an octogenarian's lifespan to earn your money back. At some stage in this company's youthful lifespan, expectations are going to be missed. It won't have to be by much, but the carnage could be awful.
Bad news comes in threes; It’s rarely a good bet to assume that one profit warning is the last, just look at Thomas Cook.
Remember investing's iron disciplines
Investors in individual shares need a certain amount of self-discipline: knowing when scheduled announcements are expected, reading them well before the market opens to give time to formulate a plan, and keeping in mind stop-losses. Perhaps the most difficult part, however, is deciding what to do when actually faced with an unexpected price fall. It's a huge question: sell and crystallise your losses, or sit tight and hope for recovery?
One key part of this is the idea of setting stop-losses. Not automatic limits in your stockbroker account necessarily, but a psychological discipline that leads to the re-evaluation of investment ideas. It is far too easy to let matters slide, and hope for recovery, than to bite the bullet and turn a paper loss into a real one. Yet it is often the differences in the way in which we treat winners and losers that makes the biggest difference to our performance. In a typical portfolio in which share performances follow a normal distribution, cutting losses at, say, 15 per cent but allowing your risers to grow automatically adds a positive skew to your investment returns. Cutting off the fat tail of disappointments before they become disasters allows you to put your money back into your winners.
Getting out early
