Why A Profit Warning Could be Good For You

For anyone who buys individual shares, a profit warning is something you will have to live with. It is not pleasant for you to wake up one morning, and see a holding in your stock portfolio down -20% or more due to a disappointing update. Yet if you are prepared to face up to a profit warning, you can learn more about what went wrong and reduce the downside risk of this happening again. 

Takeaways

• What is a profit warning

• The different types of profit warnings

• How you can learn from them

What is a profit warning?

Novice investors often fail to understand that share prices move according to future cash flows. Professional investors buy shares on the expectation that these cash flows will increase. When these expectations are dashed because of lower earnings, share prices drop to reflect the new reality. This is known as a profit warning.

The chart below is an example of a profit warning from SAP, the German software developer. March 2020 shows the sell off caused by the Coronavirus outbreak. November shows the share price drop from a profit warning! As you can see, the share price reaction is as violent as that of global sell off event!

Profit warnings come in all shapes and sizes

Your typical profit warning, a disappointment in earnings, will usually see the shares sell off. If the reason is minor and short-term, the shares will usually recover over the coming weeks and months. If it is a major one, then the shares can easily lose 40-50% of their value in minutes when the market opens.

Often the most volatile stocks will react the worst to a poor trading update. This is due to many investors having bought into an 'idea', only to see the momentum trading of shares go the other way and sell out in a panic. This accentuates the sell off.

Known unknowns also applies to stock markets

Other reasons for a stock specific sell off can be caused by one off events. Hotel businesses during a Coronavirus caused lock down will be losing money at an alarming rate. More worrying can be a bad trading update where the viability of the business is at stake. As an investor you should always ask yourself what could go wrong in a business?

Creative accounting will both be badly received by the market and will often lead to further selling in the days after it is revealed. Both NMC health and Wirecard shares were suspended after outright fraud was revealed. Both companies ended up in administration. 

Read the small print

When a company has some poor results to report on, it will not start its report with the words 'profit warning', but will use some vague terminology. Examples include, 'we are reporting profits which have not met our expectations', 'there is a revenue shortfall'. Occasionally firms will find creative ways of not declaring a profit warning, by inventing a new metric such as EBITC. Only fundamental analysis of the results will give you a clear idea how serious this profit warning is.

A profit warning can happen to the best of us

As a result, beating yourself up about it will not be helpful. You would be better served by asking yourself how did it happen and how can you learn from it. Everyone always gets in wrong sometimes. Without getting it wrong you would never have to evolve.

This can lead you to asking if you need to adapt your investment style? Did you do the work required or just jumped onto the bandwagon? Many newer investors buy the large famous tech names convinced that they will keep going up. Eventually their earnings will plateau and may even fall. Just wait till one of these firms reports a profit warning and the ensuing carnage this will cause!

Conclusion

A buy and hold investor will look at  a profit warning as a short-term bump if the long-term investment case has not changed. A novice investor will have a hard decision to take. If they have invested in a high quality company with good prospects, they have nothing to worry about.

If you bought a momentum stock which releases a poor earnings update, the shares will most likely have crashed downwards. You will face either saving what you have left or hoping that the shares will recover.

The first cut is the cheapest

When you are faced with a profit warning on a company where the outlook is poor, selling out early is best. Holding on for too long will only make things worst, and you will potentially miss out on other opportunities. Understanding that profit warnings happen, how to handle them and above all, learning from your mistakes will define whether you succeed as an investor.