Profits Warnings

There is much speculation surrounding the ‘science’ of profit warnings, their predictability and recurrence in particular

Understanding Finance

There is much speculation surrounding the ‘science’ of profit warnings, their predictability and recurrence in particular. The best publicised being the fabled wisdom that they come in threes. However, on closer inspection this statement, and many others that seem widely accepted amongst investors, does not appear to be the case.

The first piece of research on this subject I encountered was a webinar by Ed Croft, one of the co-founders of Stockopedia. This study looked at circa 250 stocks who had warned on profits in the last decade or so and looked carefully at their performance in the run up to and following their warnings.

A particular result that caught my attention was that in 63.7% of cases there were no subsequent warnings in the 18 months following the original warning. In only 4.9% of cases did the warnings come in threes – a far cry from the touted ‘fact’.

This was just one of a number of interesting conclusions from the study, but I wanted to see these results for myself. So, myself and a colleague dug up the names of a selection of large UK Plc’s whose profit warnings had made the tabloid headlines since 2007, totalling roughly 140. Having cleaned the data, we performed our own analysis on the performance. Our findings were remarkably consistent to that of Ed Croft; in 73% of cases there were no subsequent warnings in the following 18 months.

A second notable finding was that an overwhelming majority of stocks that warn underperform the market for the 18 months following. This, too, resembled the Stockopedia data closely. Leading on from this, we found that the odds of the company going bust was twice as high as that of being bought out in the same period.

My three main takeaways, which may not match those of all investment managers, are summarised below:

  • Profit warnings do not often come in threes (it is much more likely to be the only warning in an 18 month period)
  • Sell immediately following a warning (they tend to underperform the wider market for at least 18 months)
  • Do not wait for a bid (it is more likely the company will go into administration)

There will of course be exceptions, but our study is just one of many that have reached similar conclusions. But, most importantly, don’t take market myths as any more than just that; myths.

Understanding Finance

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