profit warnings come in threes2 Sep 2019 21:25
https://www.investorschronicle.co.uk/shares/2017/07/20/protect-yourself-from-profit-warnings/
By Algy Hall, Megan Boxall, Mark Robinson, Alex Newman, Julia Faurschou, Emma Powell and Tom Dines
When a profit warning causes a company’s shares to tank, there is always the temptation to view the event as a buying opportunity. That’s especially true for investors already committed to the investment merits of a company, who will in general be more susceptible to view a disappointment as a short-term, one-off setback rather than a more entrenched long-term issue. Behavioural scientists have even coined a term for this “look-on-the-bright-side” trait: confirmation bias.
So when trouble strikes, many old hands turn to the adage “profit warnings come in threes” as a necessary sanity check; best to get out quick, or stay on the side-lines, and wait for the rest of the skeletons to emerge from the cupboard. Most experienced investors will be familiar with the scenario of one warning following another until ultimately a company’s top brass throws in the towel – or has it thrown in for them – and a new broom comes in to deliver one final “kitchen sink” warning (see box) before things finally get back on track.
However, the reality is that while warnings do indeed sometimes come in threes, or other multiples, they can also sometimes be one-offs, and can indeed even prove buying opportunities (see the Bovis chart below). That means it is important for investors to have some ideas about how to distinguish between a profit warning that may prove a stand-alone event and ones that bear the hallmarks of being part of a series.
Is three the magic number?
Defining exactly what constitutes a profit warning can be nuanced, which means there is a dearth of reliable data on this important subject. Fortunately, consultancy EY has done detailed work monitoring warnings since 1999 and has run an analysis for Investors Chronicle to see just how frequently companies that warned on profits in the 12 months to the end of March 2017 did so more than once. Of 207 companies issuing warnings in the period, 30 per cent had made at least one other warning within a year of the one(s) during the period. The full breakdown can be seen in the accompanying pie chart.
While the data does not tally with the strict notion that three is the magic number when it comes to profit warnings, it certainly highlights how risky it can be to view a share price fall caused by a profit warning as a buying opportunity. What’s more, while the market does have a habit of over-reacting to bad news, even when a warning is a one off, there’s no certainty the shares will rebound from any fall (see BT graph below). Furthermore, the less at risk the company in question looks of running into further trouble, the less severe any share price reaction is likely to be. Conversely, when it is highly likely more bad news is to follow, share prices can be obliterated in one fell swoop, as has rec
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