How to profit from a warning

PROFIT warnings from the companies in which they hold shares are the last thing investors need. Such announcements are often worse than unexpected setbacks in annual results because they rarely give exact figures and raise concerns about what is coming next.

Companies that issue these warnings are usually rewarded, within minutes, with a sharp fall in their share price. That has been the fate this summer of the likes of Abbey National, Severn Trent, Mothercare, JD Wetherspoon, De La Rue, JJB Sports, Johnson Service and Pace.

Abbey was a classic case. Its shares crashed 25% from 1000p to 750p after a warning in June. Last month, chief executive Ian Harley was forced out by disgruntled City investors.

Some such as Big Food, the former Iceland, and Invensys have made a nasty habit of profit warnings, giving three or more in the past year or two. Their shares have dipped sharply and their former bosses, Malcolm Walker and Allen Yurko, have fallen on their swords.

However, these two appear to be the exceptions that prove the rule. Most companies go about setting their businesses to rights and succeed, resulting in a simple way for investors with the conviction and patience to profit from alerts.

A new study by George Bulkley, Richard Harris and Renata Herrerias of the department of economics at Exeter University shows there is not only a regular pattern of sharp share price falls in the wake of profit warnings, but also one of strong recovery a year or two later.

They surveyed 455 companies issuing profit warnings over nearly two-and-a-half years and found that 450 had survived six months later. Three had failed and two were in mergers or takeovers. Their shares lost an average of 16.5% on the day that they issued warnings and drifted lower over the next six months to end up 23% down on general stock market levels from their price before the warning. After that, the companies usually recovered their poise and their shares started to recover, outpacing the market by 26% on average over the next 18 months.

The pattern is too strong to be a coincidence. Investors with a pen and patience should be able to take advantage of profit warnings by noting their dates and buying the shares six months later. Obvious candidates are those such as Abbey National, Mothercare and JJB Sports, which have recently sounded the alarm.

There is also a clear message for shareholders hit by a profit warning from a company. Resist the temptation to sell in disgust, and hold in the hope of recovery over the next two years. But be careful not to be carried away with the idea and put all your eggs in one basket.

As with any share-buying exercise, it pays to spread your money over a number of shares. Remember, some companies slaughter their shares with repeated profit warnings - and also remember the two out of 455 that collapsed.