What to do about a profit warning?

There is nothing worse than a profit warning. There is nothing better than a profit warning. Which of those two statements do you think is correct?

The answer is …. it depends.

If you own shares in a company, the last thing that you probably want to see is a profit warning. It could mean your investment losing a big chunk of its value, almost instantly.

The worst part of it is that there is not a lot you can do about it, apart from watching the share price collapse.

Travel plans

When SMRT (SGX: S53) issued a profit warning in March last year, some of us were probably saying “Profit warning? How can you possibly warn about something that stuck out like a sore thumb?

Since its heydays around 2007, the company has seen its Net Income Margin steadily go on the slide. In 2007, the margin was a very respectable 18.2%. By 2012, it has slipped to 11.2%. But by 2013, it was in the single digits. Last year, SMRT only made S$7.20 for every $100 of revenue generated.

SMRT was only able to maintain a healthy Return on Equity, thanks to a big dollop of borrowings. This helped to reduce its reliance on shareholder funds, which, in turn, bolster returns.

Meanwhile, it was still paying out a hefty chunk of its profits as dividends. In 2007 the payout ratio was a respectable 63%. But as payouts increased, and profits didn’t, the payout ratio started to strain. By 2012, SMRT was paying out more in dividends than it made in profits.

It turned out that the profit warning was a watershed moment for the company. In a landmark deal, SMRT could sell back its bus and rail assets to the government. This could help remove a weighty millstone from round the balance sheet of the company.

Hazard warning

Profit warnings can be one of the hazards of investing in the stock market. But we should not be too frightened by them. It is important to bear in mind that the market needs to have some idea about the profits that a company could make in order to value the business.

Unfortunately, estimates of prospective profits can only be that – estimates. It cannot be known for certain because that would take away the risk element from investing. So, if the market gets its estimates wrong, then a company is obliged to warn them ahead of time.

In the case of SMRT, the profit warning, which accelerated a slide in the market value of the company, proved to be rich picking for canny investors. As the shares plumbed to a low of around S$1.00, the deal to sell back its assets has catapulted the shares some 60% to a 12-month high of S$1.60.

Part and parcel     

Elsewhere, a profit warning by Dukang Distillers (SGX: GJ8) at the start of this year sent the shares tumbling by a fifth from which the baijiu maker has not recovered. But GP Batteries (SGX: G08), which warned on profits in May this year has seen its shares climb almost 50%.

More recently, the market took a dim view to a profit warning by fashion retailer FJ Benjamin (SGX: F10). The distributor of Gap, Guess, Goyard and Givenchy provided a shopping list of problems for the market to sort through. These encompassed a falling rupiah, rising rentals, manpower shortages and aggressive industry-wide discounting. The market has not taken kindly to a profits warning from ASL Marine (SGX: A04), either.

Profit warnings are part and parcel of stock market investing. Unfortunately, there are no easy-to-follow rules about how to deal with them. That’s because every profit warning can be different and every situation can be unique.

Warren Buffett once said that the dumbest reason for buying a share is because it is going up. By inference, then, a good reason to take a closer look at a share could be when it falls dramatically, such as after a profit warning.

But while the fall could present a buying opportunity, the key is to determine whether the company has the resources, the right strategy and the management capabilities to get back up.

A version of this article first appeared in The Independent on Sunday.

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