Stockopedia subscribers will be aware that last week we published a study of 245 profit warnings as “The Profit Warning Survival Guide” … you can catch up on all the content in our quick read eBook, 30 minute Webinar and accompanying set of slides. In the next few weeks we’ll be serialising some of the content as blogs on the site. For a background to the study please do read Ben’s introduction here. This article summarises one of the key findings… the average price performance of a stock during a profit warning. The results are quite eye opening.
By combining the price histories before, during and after each profit warning in our study we built a model of the average price performance of a profit warning stock. Initially we looked at the week before a profit warning up to three months after, but the analysis was so startling that we had to push our timeframes out on both sides. It was only then that we could understand the full, complete picture.
While the majority of the drama happens on the day of the profit warning itself, the true story unfolds over a two year period. It starts 120 trading days (almost 6 months) before the event and continues to unfold over the next 360 trading days (almost 18 months) after the event. This creates a stunning visual picture we’re calling The Anatomy of a Profit Warning.
Price Performance around a Profit Warning
Here’s a chart of the average profit warning decline in all its glory. If there’s one thing to remember from our entire research study, this may be it. We recommend burning this image into memory.
Some Key Results
Notes on the journey
Contrary to popular opinion, profit warnings appear to begin up to six months before the actual news announcement. There may be a couple of explanations for this phenomenon:
Whatever the reasoning behind the accelerating decline, one of the key leading indicators of a profit warning is poor share price momentum, and accelerating declines in the fortnight before.
The real sucker punch of a profit warning happens on the day of the announcement – with more than 60% of the overall 2 year decline happening in a single day. Psychologically it’s a huge test not only for the shareholders who currently hold, but also the bargain hunters sniffing out a cheap new holding. In the ebook we studied the intraday performance on the day of the profit warning which showed little evidence of any over-reaction to the bad news but a sharp fall at the open and continuing declines. We’ll go deeper into this result in a future article.
We found that the typical share also continues to decline for the next 18 months after the date of the profit warning. There may be several reasons for this. Some investors may be reluctant to sell due to behavioural factors such as an aversion to taking losses and mentally anchoring their sense of value on higher prices. Another reason is the slow reaction of city analysts and fund management groups to the news. The bad news takes time to be fully digested by the investment community. As new research reports are published, and long term forecasts are adjusted, a headwind is created for the share price. As Paul Scott pointed out during the webinar, large investors may only be able to unwind their positions gradually over time which puts continued downward pressure on share prices. A prolonged period of underperformance often ensues.
We’ll finish this brief article with a quote from Robbie Burns, The Naked Trader:
It’s crazy to buy into a company that has just produced a profit warning. And it’s crazy to hold onto one of your shares that has just issued one. It’s more likely that it will issue another one, and just because its share price has gone down doesn’t mean it won’t be going down some more ! Robbie Burns, The Naked Trader