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Are profit warnings the perfect opportunities to buy?

Image: The Motley Fool Editorial.

There has been a deluge of profit warnings over the past few months, and the market has harshly punished those companies missing City expectations. Indeed, companies such as Devro and Sepura learned the hard way earlier this month, when shares in these groups lost more than 20% in a single day after warning about profits. 

Even though a drop of 20% may suggest that investors across the board were dumping these companies, trading data from TD Direct, one of the UK’s largest retail stock brokers, showed that more investors were actually using declines to increase or initiate positions, rather than selling up. 

Considering this data, it would appear that most investors have heeded Warren Buffett’s advice to “be greedy when others are fearful“, but is this really the best course of action for every scenario? 

Should you be greedy when others are fearful? 

Buffett also said that it’s wise to “be fearful when others are greedy“. Essentially, what Buffett is trying to get at here is that if everyone is jumping on the bandwagon, you should hesitate because in most cases when something looks too good to be true, it usually is. 

This applies just as much to profit warnings as it does bull markets. 

As noted above, data from TD shows that when Devro and Sepura warned on profits, investors rushed to buy, jumping on the profit warning bandwagon. Does this mean investors are falling into a trap by trying to follow some of Buffett’s advice, but instead succumbing to exactly what he’s also warning about?

Look at the fundamentals 

Warren Buffett is a business-orientated value investor. In plain English, this means he’s not just interested in companies because they’re cheap. Buffett is looking for good businesses trading at attractive prices, and he never buys on impulse. It’s likely any company that Buffett buys for his portfolio has been subject to months of scrutiny, and he has been waiting for months or even years to buy at a price he likes. 

Sometimes, these opportunities may come after a profit warning, but if shares in a company lose a fifth of their value in a single day, it’s likely deeper fundamental issues are going on. That said, not all profit warnings are the same, so ultimately it depends on the company in question and the scale of the warning.  

So, before you start to “be greedy when others are fearful”, you need to do your research. Jumping into a position just because the shares are falling is tantamount to investment suicide. However, if you do your research and wait for the perfect time to buy, a profit warning could offer you the perfect price, and one that’s too hard to pass up. 

Mis-timing is dangerous 

Trying to time the market, or just buying shares without adequate research can be hugely damaging to your wealth. Unfortunately, most investors don't realise how damaging these mistakes can be before it's too late. 

A recent study conducted by financial research firm DALBAR found that the average investor realised an annual return of only 3.7% a year over the past three decades, underperforming the wider market by around 5.3% annually thanks to poor investment decisions. 

To help you streamline your investment process, realise and understand the most common investor mis-steps, the Motley Fool has put together this new free report entitled The Worst Mistakes Investors Make.

The report is a collection of Foolish wisdom, which should help you avoid needlessly losing too many more profits. Click here to download your copy today.

Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK owns shares of and has recommended Devro. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.