Profit shocks: Is a share price crash a signal to rush for the exit or a buying opportunity?
By Tanya Jefferies
Profit warnings are a constant hazard of share investing - and during these troubled economic times there have been some bombshells.
Tesco's alert that earnings would be at the lower end of expectations back in January, its first in 20 years, prompted a freak-out among investors, and the supermarket giant has yet to see its share price recover or fully regain its corporate prestige.
The Tesco warning and subsequent ones from Burberry and BG Group are regarded as the 'big three' of this year, but numerous other firms have downgraded or erased earnings expectations.
A dramatic price crash on the day of the announcement is normally followed by a bounceback on subsequent days. But it always takes a while, sometimes even years, for a full market reckoning to take place.
The question for company investors - and opportunistic speculators - is whether a profit warning is calamitous or only a temporary setback to long-term prospects.
We asked financial experts to explain how best to analyse a profit warning and come to a considered decision to sell, hold or buy the stock. They also offer their take on Tesco's woes below.
The 'big three' profit warnings of the year so far have come from Tesco, Burberry and BG Group, says Richard Hunter, head of equities at Hargreaves Lansdown Stockbrokers.
They had 'shock factor' because the market wasn't expecting profit downgrades, and their share prices dived afterwards.
'The market is very jittery at the moment. You can get an overreaction to what is a trimming of a profit prediction,' says Hunter.
'In the good old days it meant there weren't going to be any profits at all, whereas now it's just they will be lower than expected.'
He says the profit warning from luxury goods firm Burberry in September went on to be corrected in two subsequent trading updates.
'Fundamentally it's not in bad shape. It's just profits are not as high as originally guided.'
In the case of BG, Hunter says the oil and gas firm has been paying a relatively low dividend for its sector, and instead of an income share it had come to be seen as something of a growth stock.
Investors were therefore shaken when it issued an unexpectedly downbeat production forecast for 2013 and 2014 at the end of October, because growth aspirations had been one of the reasons for investing in the company.
Rule of three
Many investors will be aware of the old stock market adage that profit warnings come in threes - one is often followed by more over a period of time.
It's a rule of thumb or 'observable phenomenon', according to Douglas McNeil, equity analyst at broker Charles Stanley.
'It's often because that first profit warning is not the end of the story. There has been a change in the market that management and analysts have failed to anticipate.
'When these changes occur their full implications are not understood. They are often seen initially as something of a blip and then it's only later it becomes apparent they are much more than a blip.'
Management teams often overestimate their ability to deal with the change that has occurred, but eventually realise they are not as in control as they thought, he explains.
This can be down to the quality of the corporate reporting system - it can take a while for information to make its way from the front line to the control centre.
'Profit warnings often expose that fact. They expose that a company's management information system is not as good as previously thought.'
Bolts from the blue
Profit warnings are by nature unexpected events, says McNeill.
'I wouldn't say some sectors are more vulnerable than others. There are industries that are unpredictable but people know that in advance.'
He says profit warnings are most damaging when they come from a company that people thought was predictable, but turns out not to be.
The Tesco alert back in January is an good example, and so is FirstGroup's sudden warning in March that difficult economic conditions were impacting bus operations in Scotland and the north of England, he believes.
Of FirstGroup, McNeill says: 'It was seen a year or two back as a classic defensive stock. US school buses seemed predictable. People always need to catch trains and buses.'
Although it's hard to see profit warnings coming, the first quarter of a firm's new financial year can be a time to watch out.
'A company might warn on profits a few months into their financial year when it becomes clear expectations aren't working out in practice,' says McNeill.
Also, some industries are seasonal, making most of their money at specific times of year - the travel sector in high summer, retailers at Christmas - and they will soon issue warnings if business has missed expectations then.
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