The Profit Warning Survival Guide

Lessons learned from 245 small cap disasters

Published in

Stockopedia

6 min readAug 13, 2018

There are very few events in the stock market that cause as much concern and confusion as profit warnings. Reports of an earnings ‘miss’, a slump in trading or an unexpected setback, are naturally loathed by the market. These gut-wrenching events tend to be punished with instant and savage falls in stock prices. Shareholders caught in these situations face the emotional turmoil of sudden losses and the agonising decision of what to do next.

One of the defining features of profit warnings is that they’re shrouded in market myths, which only add to the sense of confusion. For some, profit warnings are “an ideal buying opportunity”, while others believe they ”come in threes”. Some use them as “an opportunity to average down” while others don’t dare ”catch a falling knife”.

In The Profit Warning Survival Guide, the team at Stockopedia.com have set out to definitively answer the question of what to do in a profit warning. While most investors hang their decision making on gut instinct or a subjective analysis of the underlying business story, we’ve taken a long, hard, rational look at the statistics.

By conducting an analysis of hundreds of smaller company profit warnings over a three-year period between 2013 and 2016 we’ve constructed a data set that has few peers in international research. From the data we’ve set out to answer several questions including:

How far do stocks fall on a profit warning?
If a stock suffers a profit warning, is it likely to recover?
Should you buy or sell on a profit warning?
Is there any way to avoid profit warnings?
Which sectors are most hit by profit warnings?
Do profit warnings over-react and thus bounce?

The goals of our research project were to uncover the facts, debunk the myths and offer a clear statistically guided pathway for investors to make more optimal investment decisions.

Not only do our findings validate the results of many academic studies in this field but provide a unique insight into the behaviour of smaller company investors on bad news. We hope these insights will help you sidestep many of the emotional snares that entrap both individual and institutional investors alike, and lead you on the path towards more profitable decisions.

How to spot a profit warning

Security Analysts at professional brokerage firms create models to forecast the profits for most listed stocks. These forecasts tend to set the expectations of the market and thus the valuations of stocks. A company “warns on profits” when it realises that the consensus forecasts of the investor community are too high and wants the market to recalibrate expectations.

For unsuspecting investors, the first inkling of a profit warning may be the sight of a share price in free fall, and a savage price drop normally points to only one thing… bad news. Profit warnings may be due to a number of reasons including lost sales, missed contracts, supply chain issues or macro-economic reasons. Learning to gauge the severity of the news may require decoding the management phraseology used in the announcement. Before we try it’s worth clarifying a couple of points.

Firstly, it would be unfair to suggest that companies like to sneak out profit warnings. Most appear to be up-front when things have gone wrong. But that’s not to say that bad news can’t be buried, window-dressed, under-emphasised or left to the very last sentence of a press release. Indeed, many profit warnings initially sound very upbeat, only to be let down by one or two killer sentences.

In addition, some companies choose to issue their bad news mid-way through the trading day or, worse still, after the market closes. These efforts tend to be counter-productive in terms of protecting share prices and may also serve to irritate investors even more.

Profit warning bingo

Armed with the knowledge that profit warnings can be glossed over, here are some crucial management phrases to look out for…

“Broadly in line with expectations”

The number-one takeaway from financial results and trading updates is whether a company is missing, meeting or exceeding the expectations that have been set by the management and analysts. “Broadly in line” has earned itself the reputation as a very British term that fudges the facts. Paul Scott’s rule-of-thumb is that “broadly in line with expectations” is management speak that really means “a bit below expectations”.

In February 2016, health services company Cambian issued a profit warning, which included the following explanation:

“Since the previous announcement, revenues and wages have been broadly in line with expectations, but due to weaknesses in our cost management processes, it took longer to identify and manage down other costs.”

Shares in Cambian fell by 52% on the day of this profit warning.

“Below current market forecasts”

As the name suggests, market forecasts — or market expectations — are the targets set by the consensus of analysts, rather than the company itself. But management often have close ties with analysts and help them formulate the assumptions in their models. So the consensus view of analysts can be a strong reflection of the company’s own expectations, too. As such, missing current market forecasts is a declaration of failure.

In January 2013, engineering group Chamberlin issued a profit warning which included the following line:

“The board expects that the group will deliver pre-tax profits below current market forecasts for the full year.”

Shares in Chamberlin fell by 20% on this announcement.

Of course, there are degrees of severity in missing market forecasts. So on spotting this line, it’s important to figure out how serious the forecast ‘miss’ is likely to be…

Severe warnings

Profit warnings fall into two broad categories: severe and mild. Paul Scott describes severe warnings as those where profits will be below previous expectations by a wide margin. In these cases, you tend to see terminology like ‘materially below’ or ‘significantly below’.

In a profit warning in January 2016, oilfield services company Plexus Holdings, reported:

“As a result of this, the company’s financial results for the year to 30 June 2016, which are subject to external audit, will be very significantly below market expectations.”

Shares in Plexus fell by 44% on the day of this announcement.

Mild warnings

In contrast to severe profit warnings, a mild earnings miss may not be as severely punished by the market. Again, the implication is that the company will miss previous expectations by a small margin. In these statements, expect to see phraseology like ‘slightly’ below expectations.

In November 2015, marketing firm Communisis issued a mild profit warning with the following comment:

“The group expects to deliver results for 2015 that reflect double-digit growth in adjusted operating profit… but slightly below previous expectations.”

Shares in Communisis fell by 14% on this announcement.

This is an extract from The Profit Warning Survival Guide, a free e-book written by Edward Croft (CEO) and Ben Hobson (Strategies Editor) at Stockopedia.