Dear Fellow Investor

If a company in your portfolio issues a profit warning should you sell, buy more or just stay invested?

That is exactly the question I asked myself after experiencing quite a few profit warnings recently. I wondered if there wasn?t a tested rule I could follow that for example says sell immediately after a profit warning is announced and buy the position back in a few months? time.

I decided to take a look at a research studies on profit warnings to see if there is not a strategy that will make you come out ahead.

First study ? most practical

The first, and most practical, study I found was a research note written in September 2008 by James Montier when he was still with Societe Generale called Maximum Pessimism, Profit Warnings and the Heat of the Moment.

The study was also published in James? excellent book called Value Investing: Tools and Techniques for Intelligent Investment.

Why you are a bad decision maker

In the note James argues that humans are very bad at making decisions and procrastinate under pressure and thus it would be best if you have predetermined rules to help you make the best decision under pressure. And profit warnings are just such a high pressure situation.

To find out what the best decision you can make James looked at 2004 study by G. Bulkley R. Harris and R. Herrerias from the University of Exeter calledStock Returns Following Profit Warnings: A Test of Models of Behavioural Finance.

455 profit warnings

In the study they looked at what happened before and after 455 profit warnings issued by UK companies between 12 August 1997 and 31 December 1999.

What they found was on the day the profit warning was announced the share price underperformed the market by an average of 16,6%. However what happened over the next 6 months is that share price continued to drift lower, on average performing 4% worse than the market.

Sell immediately

James said this makes a strong case for you to sell immediately on the profit warning rather than be drawn into management excuses and procrastinate until perhaps the next profit warning is announced.

But the study also found that on average about a year after the profit warning stock prices start recovering and goes on to do extremely well, outperforming the market 22.4% over the next year.

Buy again after a year

James argues that this may be another good time to implement a rule to buy companies that issued a profit warning one year after the warning date.

But after a year of the stock price drifting lower you may find it very difficult to convince yourself to buy the company again. Especially if the share price, on average, lost 41% from 6 months before the profit warning to one year afterwards.

All the above numbers are however all based on averages. If you carefully look at the study you will see that all averages have huge standard deviations. This means that the returns from the 455 companies that issued profit warnings were all over the place. For example the share price performance on the day of the announcement ranged from +10,5% to -43,7%. (Technical: Two standard deviations from the mean, assuming the market adjusted returns are normally distributed)

Long term – profit warning just noise

Also, as James correctly said, if you are a long-term investor in a good business, a profit warning is essentially just noise and may be a great buying opportunity.

If you are more of a trader on average your best strategy will be to sell immediately after the profit warning and reinvest in the company one year later.

Second study ? 3 667 profit warnings

The second study I found was published in 2009 by Fayez Elayan and Kuntara Pukthuanthong and was called Why warn? The impact of profit warnings on shareholder’s equity.

In the study they looked at 3 667 profit warnings by US companies announced between May 1997 and December 2002.

They found that on average the two-day return after a profit warning was 16.59% worse than the market. Between two and 90 days after the profit warning the share price of the companies on average recovered 4.09%, so there was some overreaction.

65% only one profit warning

An interesting finding of the study was about 64,6% of companies only made one profit warning, about 23% made two and 12,4% issued three or more warnings. So only in 35,4% of the companies issuing profit warnings was there more than one cockroach in the kitchen.

Also on average the share prices of the warning companies drifted lower shortly before the profit warning due to information leakage.

The study unfortunately did not look at share prices a year later to determine if it would have been better to sell immediately after the profit warning or not.

Third study ? 2 kinds of profit warning

I then looked at April 2002 study called Stock Returns Following Profit Warnings by George Bulkley and Renata Herrerias from the University of Exeter.

They looked at two kinds of profit warnings, those that include a new earnings forecast, and those that offer only information that earnings will be below current expectations.

Not surprisingly what they found was that the fall in the stock price against the market was substantially more when the company did not give an indication of what earnings would be (-24,7%) compared to when they did give a new earnings forecast (-20,7%).

High price to book ratio companies more likely

Also not surprising was that companies with a high price to book ratio (highly valued companies) issued nearly 70% of the profit warnings.

The same as in one of the previous studies the share price performance of profit warning companies were all over the place. In 25% of the companies leading to an increase in price and only about 50% of the time leading to a decline of more than 4% against the market on the day of the announcement.

25% fall before the profit warning

They also looked at what happened to the share prices in the 12 months before the profit warning as they wanted know if the profit warning came as a complete surprise or if it followed a string of negative news about a company. And they found that on average profit warning companies lose about 25% of their value in the three months before the announcement.

Fourth study ? 87 in EU

The fourth paper I looked at was called The Relationship between the Profit Warning and Stock Returns: Empirical Evidence in EU Markets by Tserendash Tumurkhuu and Xiaojing Wang.

The study looked at 87 profit warnings issued by EU companies between January 2008 and April 2010.

The study’s findings were not much different from others I looked at. The biggest price falls recorded between one day before and one day after the profit warning. This indicates that there was a leakage of information with some investors jumping the gun.

Some overreaction

During the five days before and five days after the profit warning on average the share price response was -35% worse than the market. They also found that some of the negative price movement was recovered a few days after the profit warning which means that there was a certain amount of overreaction by investors.

More information on the future helps share price

Similar to previous studies they also found that if the profit warning contained some information on what profits would look like in future it had a less negative effect on the share price than if the warning only said that profits would be lower than expected.

The study also found that there was no big difference between the price decline of a small or large company issuing a profit warning.

In summary

So in summary this is the essence of all the studies I looked at:

  • The share price of a warning company on average performs 25% worse than the market in the 6 months before the profit warning.
  • On average the share price underperforms the market by 16% on the day the profit warning is announced.
  • The share price does recover slightly in the days following the announcement.
  • On average the share price underperforms the market for a year after the announcement most likely as investors wait to see how and if the company recovers from the fall in profits.
  • In the second year after the announcement on average warning companies outperform the market by 22%.

How can you use it:

If you are a long term investor:

  • Once you are sure the business of the company has not been deteriorated then a profit warning is just a short term set back and an opportunity for you to buy more.

If you are more of a trader:

  • Wait up to five days after the profit warning and sell after a slight recovery in the share price.
  • Buy back your position a year after the profit warning.

Please remember that the above advice is based on averages (with a lot of variance) so the share price of the company you are invested in may behave differently.

Your profit warning analyst