There is an old stock market saying that profit warnings come in threes. For investors this implies that any company which first announces such a warning should be avoided for some time. In other words, never attempt to catch a falling knife. But like many such clichés it is often wrong.
Profit warnings can occur for a whole host of different reasons, whether it be a one-off hit to trading, wider issues in the sector or more ingrained problems within a particular business. In the latter case that means bad news can take time to filter through, and yes an initial warning may be followed by several others. For example, Tesco had four profit warnings in 2015, and Rolls-Royce has announced five within the space of 20 months.
But it is interesting to note that most profit warnings are actually a one time event.
A study in 2009 by researchers Elayen and Pukthuanthong found that out of 3,667 profit warnings issued by US companies 65% were a one-off, with only 12% of companies issuing three or more warnings in a row. Another study, this time on UK companies, by James Montier, found that companies which issued profit warnings fell by 16.6% on average on the day of the announcement. However, if you bought a year after the warning was issued you could do very well indeed, with stocks in his sample group outperforming the market by 22.4% over the next year.
While buying shares after a profits warning is always risky, especially given that market sentiment can apply a further discount to the price, there are opportunities to be had. Like in all equity investments, the key is to buy fundamentally strong companies which are trading at a bargain price. Here follows three small cap companies which have recently had profit warnings. But are the shares worth buying back into?