New research shows why you shouldn’t ignore an earnings alert from something in your portfolio
Thursday 12 Sep 2019 Author: Daniel Coatsworth

Profit warnings are one of investors’ worst nightmares and it seems we should be paying close attention to what’s going on, rather than clinging on in hope of a recovery.

These warnings occur when a company admits it will no longer meet previous earnings expectations. They tend to result in a large share price fall, often more than 20% in a single day and sometimes as much as 50%.

A new study by accountant EY finds that over the past two decades 10% of UK publicly-listed companies have gone bust within a year of issuing three of more successive warnings.

That is quite alarming, particularly as there is a well-used phrase that ‘profit warnings come in threes’. Profit warnings are rarely one-off items because the first alert often highlights a new problem, the second alert typically tells of the struggles dealing with the problem, and the third covers the big decisions a company makes as it makes significant changes to fight back.

So to see evidence that a fair-sized chunk actually go bust would suggest that investors need to be more disciplined when it comes to keeping or chopping profit-warning stocks from their portfolio.

Nearly two fifths (18%) of companies issuing a profit warning in the past 20 years have warned three or more times within a year, finds EY. Of these companies, a fifth delisted over the following 12 months.

By the morning of the third warning, a quarter of chief executives and a fifth of finance directors had left their companies. And within a month of the third warning, more than 10% breached their banking covenants, finds EY. The latter means exceeding a specific ratio of net debt-to-earnings – usually a maximum of 3.5-times.

An optimist would suggest that plenty of companies bounce back after profit warnings, yet EY’s research illustrates the severity of many profit warnings and how they impact companies and investors.

So should you simply get out of a stock upon the first profit warning? It is always important to weigh up the facts in the face of negative news and not hastily sell without reason. However, we would suggest that many factors linked to profit warnings don’t become fully apparent until a company has had time to investigate following the first warning.

If you think the profit warning-related news hasn’t changed the investment case then there could be merit in sticking with a stock. Should there be more serious changes to the way it does business, such as having to adopt a new pricing model, then the investment case may no longer be worth backing.

If you cannot stomach the worries associated with a stock that issued a profit warning then get out as soon as that first set of bad news is issued.

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