What do you do when one of your stocks issues a profit warning?
It’s the hardest decision we have to make as investors. And it’s a horrible feeling, when one of your favourite companies suddenly turns round and hits you where it hurts.
If you are a stockbroker, you can pretend it didn’t happen; if you are in the market it can be a buying opportunity; but as investors we have to face up to it. There’s no hiding place when we own the shares. And our performance will take a hit. Even the smartest investor will have to face the problem at some stage. So what’s the best way of dealing with them?
There’s no perfect rule. But by thinking clearly about profit warnings, you can save yourself stress (over stocks you own), and be ready to swoop on stocks you don’t.
The temptation to ‘shoot first’
‘Shoot first and ask questions later’ is a common strategy. If your tolerance level is low, you might be tempted to sell on sight, even though it means taking a 20% hit. Sometimes a bit more, sometimes a bit less – but always very painful.
There are two big advantages to cutting and running:
• Dumping your holding liberates you from having to think further. You don’t have to waste any more time and emotional energy agonising over what you should do.
• You are no longer at risk from the ‘London Bus Theory’ of profit warnings. This says that warnings, like buses, seldom come alone – you’re most likely to see three of them in fairly quick succession.
I can’t argue with anyone who wants to go this way. Cutting losers is a good discipline.
But like any rule in investment, it doesn’t always produce the best outcome. An obvious problem is that the market often overreacts to shocks. Bad news can send the shares down further than is justified as the move simply gets overdone.
There’s also the sense that the market might be offering us the chance to buy a stock we fundamentally like at a much cheaper level. If you held it before the warning, you must have liked the story behind it. This is a very seductive line of thought. And sometimes it can be right.
Can management be trusted?
The recent performance of Dialight (DIA) shares is a great illustration of both lines of thought. This LED lighting specialist has been a market darling in recent years, achieving strong profit growth and being rewarded with a high price/earnings (p/e) ratio.
The first sign something was wrong came last June. Management said the first half would be weak, but it expected to make up the lost ground in the second six months of the year. This knocked the shares by 20%. Amazingly, they then recovered to make a new high in early September. One-nil to the ‘buy on an overreaction’ camp!
They rebounded so quickly because an interim results statement in July reiterated confidence in the full-year outlook. So the market probably assumed the earlier sluggishness was a blip, and there was no further deterioration in trading. Dialight is a well-liked stock, so people were no doubt keen to give it the benefit of the doubt.
But then ‘London Bus Syndrome’ struck. In September, management’s confidence gave way to an admission that the full year would in fact disappoint. Lost sales wouldn’t be made up in the second half and it would be a flat year for profits. The shares fell 17%. But even then, this second warning had only taken the share price back to the where it was after the initial warning. So this was only an equaliser for the cut-and-run strategy.
The optimists were right – at first
With hindsight, the market was being very indulgent. The outlook had deteriorated without the shares really suffering. But then the cut-and-run boys scored a decisive victory. A trading update in November reiterated guidance but gave no hint of an upturn in orders. The shares were drifting down now, and the third bus duly arrived in January with news that revised forecasts wouldn’t in fact be met.
This third warning took the shares down another leg to 700p – exactly half the level they were in September!
In my next Penny Sleuth I’ll take a look at a small growth stock that has just issued a profit warning. Is Synectics a buying opportunity, or should you cut it and move on?