VALUE INVESTING
Dealing With Profit Warnings

By Stephen Bland (TMFPyad)
May 20, 2005

Recently, a couple of shares picked for my Value Investor newsletter issued profit warnings. These notices refer normally to the directors' opinion that existing analysts' profit forecasts for the current year will not be met. They may also be issued to contradict earlier forecasts from the company itself in the light of more recent information about their business.

Warnings are a risk of short-term trading but the big question for those in a share that has warned is how to proceed from here on in. My answer from a value viewpoint is that this depends upon the nature of the warning and how it affects the value perceived by the investor in the share.

One near certain event is that the price will be hit hard immediately the market gets the news and before an investor can get out at the pre warning price. The result is that any calculations and consequent decision as to what to do next will have to based upon the new lower price. At that point there is no future in going back and looking at the original cost or any other pre warning price.

With value, remember that you never look back. Past price action is of no consequence whether you are selling or buying. In the case of warnings, the price has been hit, it happens, and you have to live with it and proceed accordingly. Value selling decisions are always made on the current price and the current fundamentals so that the purchase price is virtually irrelevant. For a holder, all that matters is the constant value test – does sufficient value remain in this share for me to continue holding it?

The effect of the warning will be that some of the value that you believed earlier to be there will have evaporated, usually with regard to eps and dividends. Net assets may have been hit in some cases and also, cash balances may have been turned into debt. Each case will be different.

However, the most common effect of a warning is that current year and maybe the following year's eps will be lower then previously forecast, perhaps dividends too. Often though, a net cash and good net assets position consisting of a lot of valuable assets like property will not be hit. And if those property assets include some old valuations which you have reason to believe are worth more than book, then this too is unlikely to be affected by the warning. A case in point with one of the Value Investor tips recently hit by a warning. With a decent dollop of property, some at old valuations, it actually offers better value now than before.

It may sometimes transpire that the share now offers better value at its new price than it did before the warning. This will happen where the price fall is proportionally greater than the effect upon fundamentals of the warning, actually improving some or all of P/E, yield or P/TBV. If you believe that to be the case, then my advice might be to hang on depending on the weight you attach to various value features.

The problem with this is that a lot of value depends to some extent on market perception rather than absolute fact. And because the share's reputation will have been damaged by the warning, the market will not be in any mood to do it any favours, making it harder for the value to out and to make a profit from the new lower price. Nevertheless I still say hang on if you consider the share to offer good value at its new price. It may be a long wait but if you are right, sooner or later that value will out. This applies particularly to asset plays.

Taking the other possibility, that you believe the share has now lost too much value, then dump it straight away and take the hit. Some hits are inevitable with value trading so you need to be able to live with that threat and roll with the punches when they come.

One other difficulty with warnings. It has been said, almost as a superstition, that warnings always come in threes. Behind this is the feeling that some companies don't always come fully clean with a first warning, keeping something back or remaining over optimistic in the hope that things will recover before they have to deliver any more bad news. I've not seen a study of warnings to see whether there is any merit in that, but it certainly does happen sometimes that just when you thought it safe to go back in the water, the monster reappears. But not always.

If you subscribe to the threes idea then you'll likely want to dump the shares quick. Personally I don't buy that view automatically but I do understand it. It's a question of not giving the share the benefit of the doubt. I tend to judge each case on its merits and see little reason to dump a fine asset play for example, even if its profits have been shot to hell.

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