Profiting from profit warnings

By the time you read this London will have moved into Tier 3 lockdown. I spend my day sitting at my screens and trading shares so little has changed for me aside from the IC’s Christmas beers being sunk (There’s always next year – The Editor). But it’s a devastating blow to the hospitality sector at what should be its busiest time of the year.

There is also ‘new variant’ of coronavirus to worry about and Brexit once again looms large on the horizon. I believe we’ll see a deal because, if the only thing in the way is disagreement over fishing, then one can only assume that bigger fish have already been fried. These delays in negotiations seems pointless unless both sides want a deal, and I am sure I speak for many when I say we are sick of mealy-mouthed politicians, who seem hell-bent on dragging talks out for as long as they can. I bet if someone were to tell them their pay ends next week then – guess what – there would be a deal next week!

Nevertheless, we are also being told to expect “no deal”. And, either way, investors need to tackle this issue. In my view, it’s prudent to take some risk off the table. A no-deal seems unlikely but if we are once again expecting runs on supermarkets (it has happened once this year already) and delays on goods, that may filter through to markets - and having a weighty cash position will be a cherished one.

If we do get an agreed deal, and the market rallies stupendously, it does mean I will miss out. But as a trader my goal is always to protect downside risk first. As I said last week: think about what can happen, and what that means for your trading account. Your goal is to stay in business and trade another day.

Following on from last week’s theme of aiming to profit from low-quality companies, Provident Financial Group (PFG) is another company which has had a disastrous few years for long term investors. Disgraced fund manager Neil Woodford found out the hard way, when it announced a profit warning that pre-exceptional profits from one division had gone from £60 million to a pre-exceptional loss of between £80 and £120 million in just two months.

Provident Financial was in the FTSE 100 at the time and Chart 1 shows the value destruction over the course of several weeks.

Many investors think that profit warnings are always unlucky. But traders know differently. Chart 1 shows the price action of the stock in the months prior to the big collapse in the price. The price had already gapped down in June (left arrow) and we can see increased volume here. High volume means high amounts of shares swapping hands. This was the first warning sign alongside the fact that the price was now tracking below all of the moving averages. The price failed to bounce and continued to slide lower – more warning signs that not everything was rosy within the business. The market is generally efficient when it comes to liquid stocks and those in the know will always sell before the bad news whether this is legal or not. The good news for us is that often (although nothing is ever guaranteed) it shows up in the charts.

When something stinks – there is usually a reason. Check the chart for increases in volume on down days (often institutions unwinding positions), previous gaps down (generally avoid going long stocks that have already gapped down once), and down trending stocks (check which way the moving averages are pointing and where the price is in relation). Alpha generation is as much about avoiding bad smells as it is picking winning trades.

Fast forward three years later and the chart looks very different. Chart 2 shows the last thirteen months of trading history. You’ll notice immediately that the price has halved again from the profit warning in 2017 – showing that corporate turnarounds can take time and that we should follow the chart rather than the spin the directors use in company announcements.

I’ve drawn a line of resistance on the chart that the stock has now broken through. Importantly, the moving averages are starting to turn back up, suggesting a potential new trend.

The stock has doubled from the lows too – again suggesting that demand is taking out limited supply in the market. It’s taking a breather now and so there may be an opportunity to get long once the stock has consolidated and allowed profit takers out and new position takers in.

A quick check of the cash flow statement shows that the company is able to sustain itself (at least for now), and so I’d like to take a long position if the stock can break through the right arrow on Chart 2 around 320p.

Stop placement is tricky here. The stock is volatile and so too tight a stop will see us relieved of our position, whereas too wide a stop will take on too much risk. A stop underneath the 50 EMA if the stock breaks out would give us ample breathing room – remember to adjust your position size downwards to compensate for the wider stop. Not all position sizes are equal as we saw in my article ‘Size Matters’ (1 August 2019).It is often the stocks that nobody thinks much of that go on to do the things that nobody expects. This is due to battered expectations, and it can be a good opportunity for traders to take advantage of negativity. My belief is that Provident Financial is still a ‘bargepole share’ for many investors and so any moves upwards may continue to be sharp. But remember that stocks like this can move sharply down too.

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