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What is a profit warning anyway?

Broadly, a profit warning can be described as a statement from a company where it issues some kind of guidance that financial results will not be as predicted. They are often issued as part of regular trading updates, or in exceptional circumstances, can be in a one-off message.

Are they easy to spot?

Not always. Companies don’t go shouting from the rooftops about declining profits and given that most updates are couched in the most optimistic of terms, the warning may be merely reduced to a few lines, the equivalent of saying it through gritted teeth. At other times, it may be loud and clear.

Why look at profit warnings?

Profit warnings generate significant volatility in share prices. Market expectations are for companies to keep on growing, so any deviation to this plan is viewed as very negative. Sell-offs can be massive: depending on the severity of the warning, a share price could collapse significantly. This can provide a buying opportunity, as history has shown us that prices over-react to both the upside and downside.

A cautionary tale that not all profit warnings lead to this over-reaction. In many cases, profit warnings lead to further profit warnings down the line, because the conditions that caused the first warning gain momentum. That is why they have to be analysed carefully.

Why bother reporting profit warnings?

Companies have a duty to report to their shareholders significant information which affects their investment. If a board decided to omit a warning, potentially it could forgo the volatility effect in the share price in the short-term, but in the medium and longer terms the effects would be worse and their credibility will be damaged.

How do you analyse profit warnings?

My analysis is mostly fundamental. Whilst technical analysis can be valid, in times of profit warnings the price often rapidly breaks any type of support/resistance, giving rise to the phrase ‘trying to catch a falling knife’. I am much more interested in the reasons behind the warning: are the events that caused them temporary and easily reversible, or are they difficult for the company to control.

Candidates that fall into the first set of reasons are often good recovery plays, for if the conditions can be reversed normality can be resumed. The trouble is differentiating them from the second set; many businesses have gone to the wall because they could not adapt to the changing macro-environment.

I also face up to the reality that there is a third category: the ‘too complicated’ pile. My knowledge is not full, and there will be cases where it is not sufficient to even make an educated guess to future performance.