UK companies this year issued the highest number of first quarter profit warnings since the financial crisis, says consultant E&Y.

The number of warnings was up more than 20% year-on-year as companies were hit by domestic Brexit-related uncertainty as well as global growth fears.

It can be painful for shareholders when a company downgrades profit expectations but not all profit alerts are equal.

In this article we will discuss the different levels of severity of warnings, whether you can anticipate them in advance, how the market reacts and when and if companies can recover.

DIFFERENT WARNING LEVELS

It’s a human trait and a handy self-defence mechanism to downplay the ugly truth and companies are no different. A ‘broadly in-line’ statement is mostly interpreted as a small miss against the market expectations.

Share price reactions can vary quite a bit, but generally a 5% to 10% fall in the share price would be a common reaction.

‘Moderately below’ market expectations is a clear statement that a company’s performance has fallen short of what the management believes is the consensus expectation. It is generally understood by market professionals that this means 10% to 15% below expected earnings.

Share price reactions with these types of warnings can be more brutal, a ‘shoot first, ask questions later’ approach, and can range from 20% to 30%.

Banknote printer De La Rue (DLAR) is a good recent example of a mild profit warning, leading to a punishing 26% fall in the shares on the day.

The consensus of investment analysts before the announcement was for revenues of £510.8m and operating profit of £67m, while the company came up short with profits of £60.1m, a miss of 10%.

The company pointed to the increasingly competitive banknote print market and warned of significant headwinds in the year ahead. These are all factors which cannot be easily fixed by management actions.

WHAT ABOUT SEVERE WARNINGS?

A company will sometimes report that earnings are ‘significantly’ or ‘materially below’ market forecasts. In these cases, investors should be bracing for a 20%-plus miss or perhaps a loss against a previously expected profit. Share price reactions can be falls of 50% or more.

On 17 May, recruitment company Staffline (STAF:AIM) warned that trading had slumped in the first quarter on Brexit worries. The shares fell a staggering 61% to 327p on the day of the warning.

The company said that it expected the current uncertainty to continue to depress temporary recruitment ‘throughout the current year’.

The shift from ‘temp to perm’ is also impacting margins. In particular the company has seen a sharper than expected fall in demand from the higher-margin automotive sector and associated supply chain.

At the same time a high number of transfers have occurred in the higher-margin driving sector, resulting in a further dilution of group margins.

CAN INVESTORS ANTICIPATE PROFIT WARNINGS?

One study showed on average a share will underperform the market by around 7% over the six months preceding a profit warning.

This can be explained by two factors; business fundamentals have already started to deteriorate and the market has begun to price this deterioration into the share price; and insiders may have leaked some information to analysts.

Researchers at the Bank of England examined the financial health of just over 500 firms issuing profit warnings between 1997 and 2001. They found that over 75% of those firms experienced a fall in profit margins between the set of financial accounts immediately prior the warning and the subsequent year-end set of accounts.

Crucially, fewer than 20% of firms in the study that issued a profit warning subsequently went on to reverse the trend in the same financial year. In fact, there was evidence that a decline in profitability is not temporary, with around 80% of firms failing to grow their profit margins to pre-warning levels within at least two years.

These results show that deteriorating financial health is a trend that can take firms a long time to reverse. Having issued one profit warning, their slow rate of recovery makes it likely that at least one other profit warning will follow.

These studies suggest that the chances of a stock returning to levels seen before a warning is very small, especially in the year following the first profit alert.

IT’S NORMAL TO WANT TO HOLD ON

Research has shown that the pain of a loss is twice as powerful as the satisfaction of a gain, first discovered by Amos Tversky and Daniel Kahneman, commonly known as the fathers of behavioural finance. This is sometimes called loss aversion. In practice it means that investors hold on to a losing position hoping that it will recover.

James Montier, a respected analyst and behavioural scientist, has noted that profit warnings have a heightened impact on investors, which causes them to get their timing wrong.

In Maximum Pessimism, Profit Warnings and the Heat of the Moment, he explains that evidence shows that stocks which warn continue to do poorly for around a year. ‘Hence you should sell at the profit warning,’ he says.

‘Of course, we don’t; we procrastinate and often end up doing nothing for a long time.’

Montier adds that around 12 months after a profit warning, the prices of companies begin to recover, but it’s at this point that people are finally getting around to cutting their losses – far too late.

RECOVERY FROM A WARNING DEPENDS ON CIRCUMSTANCES

A study by UK finance professors George Bulkley, Richard Harris and Renata Herrerias looked at 455 profit warnings issued between 1997 and 1999 and tracked the stocks until 2001. Unlike some of the other studies that we discussed, this study looked further ahead. It tracked future earnings announcements that were released to the market.

It found that between 12 and 24 months after a profit warning, the average cumulated excess daily returns of these stocks was a positive 23% relative to  the market.

In other words, the stocks showed strong signs of recovery between one and two years after the warning. This can be explained by analysts being slow to change their opinions, even in the face of new information.

So, with some patience all might not be lost in holding out, but this is predicated on seeing some improvement in the business fundamentals.

In general, if a profit warning stems from a clearly identified problem that looks like it can be fixed by short term management actions, the chances of a full recovery in the share price are good to fair.

However, anything related to falling demand for a company’s products or a rapid change in the competitive landscape is usually bad news for the longer term development of the business and hence the share price.

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