How to spot a hidden profit warning

With The Right Side, my aim is to help you become a better investor. I want to help you make money and stop you losing it.

Last Wednesday, I looked at the best way to use stop losses. They can help you keep small losses from becoming big ones. And I touched on the curse of profit warnings.

Today, I'd like to look at what I call the three phases of profit warnings and show you how to be prepared for them. What I've found over the years is that profit warnings tend to fit a pattern. Spotting these bombshells early could save you a fortune, believe me.

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The trick is to recognise the tell-tale language in company announcements.

Why management releases the pain in three instalments

Management can't delay bad news forever. In the end the truth will out. But there are reasons why it's better to drag the pain out by being economical with the truth.

The first is to do with costs. When a company is struggling, the last thing it wants to do is admit it to its suppliers. Everyone from your stock supplier to the window cleaner will want his money upfront. Who's going to give you nice credit terms if there's any chance they might not get paid?

Large-scale suppliers normally insure themselves against a big customer going bust. But in January this year, many of HMV's suppliers were told that they wouldn't be insured against HMV not settling its bills. "Right, say the suppliers. "It's cash upfront for this job." And if you're already struggling, that's the last thing you need.

The second reason bad news is held off is to do with sales. When you buy your groceries, you probably aren't too bothered about the financial position of the store. But large corporations certainly do mind. Usually there's a dedicated purchasing department, staffed with hard-nosed dealers that extract the best terms with suppliers.

If you're the buyer and you want to renegotiate terms with your supplier, you'll be in a much stronger position if he's on the ropes. Just look at the embattled care-home provider, Southern Cross. The local authorities knew that many of the Southern Cross homes had a lot of spare capacity (empty beds). The local authorities were the biggest customers; they drove a hard bargain and Southern Cross was already in too much trouble to fight back.

Blurting out the extent of your business woes erodes your bargaining power with customers. So you try not to do it.

The third reason to downplay and drag out profit warnings is to do with directors. These guys don't want to be seen to be presiding over a disaster story. And they certainly don't want the share price trashed. Their bonuses are most likely linked to a buoyant share price.

To save face (and wealth), it's likely directors will play down bad news and hope that they can rescue the situation before things get worse and the share price gets trashed.

The problem is, bad news can't be repressed forever.

Look out for the profit warnings spiral

The first profit warning probably won't even look like one. In fact, to the uninitiated, the phrasing of the news release will probably look like a jolly good little story.

But there'll be a sneaky little sentence tucked away somewhere a phrase laying the foundation for the second profit warning further down the road. I'm talking about a small suggestion that a cost is going up, or a particular market is tough' or challenging'. It may be a technical issue that's causing some difficulties and delays. Not to worry' is the message we're on top of things. Look at all this other good news!'

The point is that, in the release, there'll often be more good news than bad. It's the same strategy that got two of Downing Street's spin-doctors sacked; a good day to bury bad news' and all that.

That's why you need to read company announcements at source and not via newspapers you may miss the real' story. You can download regulated news releases from the stock exchange website.

View the first warning as a pre-amble, ready for the second warning which will nearly always come. And it's the second profit warning that's the biggy.

This comes after management have held off publishing the bad news for as long as possible. Now they have to admit that the problem tucked away in the earlier warning is more serious. To continue to cover up, hoping for a recovery could land management in serious trouble. If it all goes wrong, directors could be up on charges of fraud and deception.

This is the warning that's really going to hit the stock price. And that's exactly why I think it's usually best to dump the stock at the first sign of trouble. That is before the situation gets so bad that directors have to let everyone know what's going on.

After the second warning, things are out in the open. Now the company will find out how competitors, employees, customers and suppliers react. Will the rats desert the sinking ship?

Depending on how this pans out, you may get a third profit warning.

This is where you've really got to watch out. The last sort of business you want to be invested in, is one that's caught in a vicious circle. That is a downward spiral where various stakeholders start to distrust the business and defect.

The way to think about profit warnings are that they come in three phases. It may take management 10 releases before they get to the last phase. But the key is to try to look out for that first warning. Don't rely on a newspaper to do it for you. Get hold of the release and look for any phrases that suggest the start of a more serious problem.

And for Heaven's sake, try to ignore any comforting words that they're dealing with the problem and you shouldn't worry. Consider the bad news and decide whether you're still comfortable holding the share. If not, get out.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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