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The Anatomy of a Profit Warning

Tuesday, November 22, 2016 10:11
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(Before It's News)

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.

5834080a8f194Cursor_and_1_1_md.jpg

  • The horizontal axis shows the number of trading days before and after the date of the profit warning (day 0).
  • The vertical axis shows the price performance as a percentage of the starting value at a date 120 days before the profit warning. 
  • The blue line and area signifies the price performance of the average profit warning.
  • The grey line denotes the return of the market average (FTSE All Share) over this timeframe expressed as a straight line. The grey area signifies the opportunity lost by holding onto a profit warning stock.
  • NB – we used the first 135 profit warnings in our database in this chart study to ensure 18 months of ensuing price history.

Some Key Results

  • On average, prices begin falling by 6% in the 6 months before the warning.
  • The average price decline on the day of the profit warning was -19.2%.
  • A noticeable further decline followed for two to three months after the warning, possibly coinciding with further earnings news.
  • Over 12 months later there was, on average, no significant reversal in the price decline which continued to fall another 10% after the fall on the day.

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:

  1. The stock’s fundamentals and peers in its industry group may have already started declining before the announcement.
  2. Company insiders (directors or other individuals close to the company) may have leaked information to analysts or to other institutional investors.

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

Remember you can download “The Profit Warning Survival Guide” resources  in our 1 hour read eBook, 30 minute Webinar and accompanying set of slides.  

Stockopedia

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