How to cope with the surge in profit warnings

This guest post comes from occasional contributor, Rob Davies. Rob manages the Smart Dividend Fund.

Autumn is traditionally the season for profit warnings but this year is bringing a more bountiful crop than usual. According to Ernst & Young, there was a 40% increase to 79 in the third quarter. And there have been more since.

Some of these have surprised the market while others have merely confirmed suspicions that not everything is rosy. No one likes to deliver bad news so it is human nature, even for Chief Executives, to delay giving it out for as long as possible.

By the time companies have reached the start of the fourth quarter of the year, it will be pretty obvious what the overall result for the year is going to be within a reasonable margin of error. Whatever happens in the fourth quarter it is unlikely to alter the final outcome that much.

Clearly, this year, with its spate of profit warnings, is not going as well as most bosses had hoped. What is surprising is the range of industries that are telling us how tough life is.

Profit warnings left, right and centre

The woes of the oil and mining companies have been well documented and the cause – low commodity prices – is clear to all.

Other industries where problems are not a surprise are luxury goods manufacturers selling into China as more modest levels of growth, and a crackdown on corruption has made life harder there.

Another sector whose problems are apparent to all are supermarkets and indeed retailers generally. Not only have competitors joined the fray with ultra-low pricing on a narrow range of products but the Internet continues to grab a rising share of discretionary spending because of its sheer utility and ease of price comparison.

More surprising have been the words of caution from companies supplying the booming house-building industry where rapid growth is apparently getting harder to sustain.

An overstimulated and exhausted business cycle

It is hard to identify any single factor that unites these businesses except perhaps the fading of the massive financial stimulus that started in 2009 with very low-interest rates and Quantitative Easing.

That worked well initially as it acted to use up spare capacity. Eventually though, no matter how cheap money is, if customers don’t spend any more when they come through the shop door, or they see no need to replace a car they only bought three years ago growth will drift back to the long-term trend. Which, in the mature economies of the West, is probably around two to three percent.

In order to grow faster than that a company has to either create an entirely new product with a great idea or increase its market share at the expense of others. The latter of course is a zero-sum game as one company’s gain is another one’s loss of market share. In the end, both probably suffer from lower margins so it is hard to even preserve profitability.

All we are really seeing is an exercise in managing expectations as we approach the end of an unusually long business cycle. Chief executives tend to have fairly short shelf lives these days as professional managers hop from one company to another as part of their campaign to leapfrog peers in their own company to win promotion. How often have we heard the claim that Mr, Mrs or Ms So and So has a fresh pair of eyes and will tackle the problems differently?

Those who benefited from QE are now finding it harder to maintain the growth that QE delivered as a single-use remedy. Now that has run its course growth must come from more mundane business techniques.

In the end, it is all about growing the top line and attempts to supercharge these by takeovers, increasing debt, incentives or marketing spending usually fail with consequences we can see in fallen corporate titans everywhere.

It’s time to suck it up

Profit warnings are really just a crude way of CEOs saying:

“Life is tough. All that guff I gave you a few years ago about going for growth was just hot air. In reality, we are not going to deliver double-digit growth in a world where GDP is growing at 2 or 3 percent and inflation is 1% if you are lucky”

As investors, we need to man up and accept that business has cycles and we have been lucky enough to experience a remarkable recovery in the last six years courtesy of central banks and governments.

That has finished; it is over. Get used to it and be prepared for modest returns for the foreseeable future, but with a few holes in the road on the way.

You can try picking stocks to avoid the pitfalls. However, Brinson and his colleagues in Chicago demonstrated decades years ago that 90% of your returns come from asset allocation. Spending hours attempting to dodge the companies that might fail is simply not worth the time.

So ignore profit warnings. Just buy the whole asset class and accept the business cycle.

John says: Obviously I would disagree with Rob’s last sentiment that stock picking is not worth the time. However, I do agree that there is a noticeable pick-up in the number of profit warnings and dividend cuts. I also pointed out the decline in aggregate UK corporate earnings in this FTSE 100 review. How long this lasts is anybody’s guess, but perhaps Rob is right that the current post-crisis business cycle is ending, which may mean another recession is just around the corner. That may not be a bad thing as desperate attempts to avoid a recession usually just store up more trouble for the future, in my opinion.

Author: John Kingham

I cover both the theory and practice of investing in high-quality UK dividend stocks for long-term income and growth.

2 thoughts on “How to cope with the surge in profit warnings”

  1. Great article. Many people to often forget, that we have business cycles and it is something we must to live with. Moreover, actions taken by governments and central banks stimulate the economy, but in most cases it is “artificial” growth. You cannot count on miracle, if you just inflate the statistics. I like the fragment about companies, that in order to growth need to create entirly new product. It is the same thinking, that is the base of start-ups; solve the problem, which hasn’t been solved yet or improve 10 times the exsisting product. Politicians to often forget, that the innovations drive the only truth and healthy growth. Nowadays, when we look at GNP we usually see “horizontal” growth; produce more, faster, more efficient the same things. This kind of thinking creat a lot of pathology (e.g. companies deliberately creat goods with shorter life time; the consumer will need to come back faster for the new product). No need to mention, that GNP is a very poor measure of real quality of life or state of environment. In my opinion, the world should more focus on inequalities and how to enable e.g. China and India to growth healthy. People from these countries want the same quality of life like in USA/UE, but right now it is impossible to achieve this without great advancement in technology and economical thinking.

    1. Thanks. You’re right that business cycles are a fact of live, but personally I would prefer it if government went back to being countercyclical rather than just always trying to push the economy upwards/forwards. Boom and bust is not a good system and it has definitely not been consigned to the history books (regardless of what Gordon Brown thinks/thought).

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