Tuesday 21 February 2017 3:11 pmSchroders Talk

Three questions to ask on a profit warning – your reporting season survival guide

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  If you’ve ever felt there was more financial and business news around at this time of year than any other but weren’t sure why, the reason is something known as ‘reporting season’.

All UK companies are required by law to publish their annual report and accounts within three months of their financial year-end and the great majority operate on a calendar-year basis – hence now is the corporate equivalent of rush hour.

Of course there are always a few swots who hand in their homework at the first opportunity but most businesses tend to hold back for a month or two to make sure everything is in order.

Then, from late January to early March, a huge amount of information is unleashed into the public domain. As they cover a company’s whole year, these can be pretty large reports and there is usually something interesting to pick out from them.

Since companies are acutely aware investors can be a nervous bunch, they will have done their best throughout the year to ensure what they publish does not come as too much of a shock.

Sometimes, however, this is just not possible and – whether it is because a business was holding back from coming clean in the hope things might improve or else it is only a recent development – surprises can and do occur.

When such surprises are announced, they are known as ‘profit warnings’ and, while they can of course be positive as well as negative, it tends to be the latter variety that make the big headlines and generally grab people’s attention. The current reporting season has already seen a number of high-profile profit warnings that have wiped significant chunks off the value of some very large businesses.

Even for seasoned professional investors, such price falls are hard to take in your stride but, rather than succumbing to the natural urge to panic, anyone who owns the shares of a company issuing a profit warning needs to analyse its implications in a rather more cool and detached way. As such, on The Value Perspective Blog, we thought it would be helpful to offer you our ‘survival guide’ to reporting season.

Rather than panic then, the first thing to do is to overcome your initial disappointment and instead think about what you can take from one silver lining inherent in every profit warning. This is the fact that not only is there some new information now available about the company, there is also some new information on the stock market – the share price has moved. Often substantially so.

In these situations, we like to consider our options using the same, consistent framework – partly because it stops us running around like headless chickens but mainly because it helps us, on average, to make the right decision about our next move. We therefore look to answer three important questions.

Question 1: Has the piece of bad news affected our view of long-term profits?

Holding shares for the long-term – say, five years – comes with the territory when you are a value investor and, clearly, when you are buying assets that are growing cheaper – which also comes with the territory – short-term profits could be coming under a lot of pressure. That, however, is only a problem if the reason that is happening means the business can never – ever – recover its profits.

Question 2: Is the bad news something that cannot be changed over a reasonable period of time?

This is by no means an easy question to answer but the reason we ask it, broadly, is because we are trying to work out whether or not the long-term quality of the business as we perceive it – either good or bad – has been affected and, along with it, the prospects for its long-term profits. After all, those long-term profits are the reason we bought the shares in the first place.

What value investors have learned over the years is that, in a large proportion of instances, the longer-term prospects for the business have not changed hugely as a result of the short-term movements. Sometimes they have changed – but, more often, they have not. That is very important to bear in mind – as is the third and final part of the puzzle we need to assess.

Question 3: Has the risk increased?

The fear surrounding the business certainly will have increased – when a profit warning is announced, the company grows defensive, headlines grow bleak and, understandably enough, people grow scared. But risk is different – what we want to work out is, as investors, have the chances of our permanently losing our money genuinely increased?

In other words, has our money gone for ever or is this just part of the natural cycle of companies having a tough time? To reach a conclusion here, we look very closely at the strength of the company’s balance sheet, how much debt it has and other indicators of risk. Sometimes when short-term profits come under pressure – for example, because they are needed to pay interest on debt – the risk of a business can hugely increase.

This framework – the idea there are only three things an investor really has to bear in mind in the event a company issues a profit warning – enables us to step back, tune out all the ‘noise’ of those negative headlines and think about the issue deeply and in as rational a way as it is possible to do in such a situation. Is this new information a real game-changer or merely scary? Is the share-price fall a trap or an opportunity?

  • Nick Kirrage is an author on The Value Perspective, a blog about value investing. It is a long-term investing approach which focuses on exploiting swings in stock market sentiment, targeting companies which are valued at less than their true worth and waiting for a correction.

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