Red flags the pros look for to spot potential profit warnings

Profits warnings can prove disastrous for investors. A company’s share price reflects investors’ collective view of what the business is worth both today and in future – the revenues and profits it is expected to achieve in the years ahead.

When a company says previous forecasts of profits now look over-optimistic, that view inevitably changes for the worse – and the shares fall accordingly.

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Sometimes, those falls can be dramatic. Shares in Vistry Group (LSE:VTY), the housebuilder, last month fell more than 35% after it recently warned that underestimates of the cost of a number of key projects would hit its profits for the next three years.

In September, the share price of luxury carmaker Aston Martin Lagonda Global Holdings Ordinary Shares (LSE:AML) slumped by more than 20% after it revealed profits will be lower than expected this year.

Just a few weeks previously, shares in the pest control business Rentokil Initial (LSE:RTO) fell 18% following a similar announcement.

Profit warnings are common

Worryingly, profits warnings are remarkably common. In the first half of 2024 alone, 119 UK stock market-listed companies issued such an alert according to data from the consultancy EY; that number was actually a little lower than in previous years, but millions of investors will still have been caught out. It pinpoints retail, household goods, home construction and credit services as particular hotspots for profits warnings this year.

Against this backdrop, it makes sense for investors to monitor their portfolios carefully – to keep an eye out for the early signs that a profits warning might be on the cards. You won’t automatically dump your shareholding if you suspect a profits warning is coming, but you will at least be able to make an informed decision about whether to sell or hold.

So, what exactly should you be looking out for? We asked professional fund managers about the red flags they watch for to alert them to the possibility of a potential profits warning ahead.

Each of the managers runs a fund included in the ii Super 60, ii’s selection of rated investment funds.

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Emma Moriarty, portfolio manager, CG Asset Management, manager of Capital Gearing Trust

“The first places that we look for signs of future weak profitability are – perhaps counterintuitively – on the balance sheet and cash flow statement. One thematic issue that we have found in the new operating environment is that companies, particularly those with long duration assets, such as infrastructure and real estate, do not have the appropriate balance sheet for a ‘higher for longer’ interest rate environment.

“Over previous decades, when interest rates were low across developed market yield curves, the impact of financing marginal investments with debt was positive. This situation has now largely reversed itself.

“Early warning indicators of potential trouble include high levels of gearing, floating-rate debt or short-term fixes with interest rate or refinancing risk. We also look to cash flow statements: companies can turn cash flow negative while still reporting positive profits.

“That said, where we otherwise have high conviction in a position, we tend to sell as a last resort. We tend to be long-term holders in our equity positions and find it far more constructive to engage with management and boards to push for better capital allocation and balance sheets which are more appropriate to the current interest-rate regime.”

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Cormac Weldon, co-manager of Artemis US Smaller Companies fund

“When we look to buy a company, we consider the upside potential – what will make the share price move over a reasonable period? And what are the downsides – what might undermine progress? We are looking for asymmetry. In other words, where does the upside potential heavily outweigh the apparent downside risks?

“You can’t avoid profit warnings, but with research and skill you can reduce the chances. Of course, the other thing that is essential is to monitor progress. Are your expectations being met? We look very closely at the trends – market share growth, profit and the like. One illustration of a red flag might be if sales growth is in line with expectations, but margins are becoming squeezed.”

Neil Hermon, portfolio manager of the Henderson Smaller Companies Investment Trust:

“Potential indicators of a possible profit warning include: lead indicators, both macro and real-time data; increasing accrued income balances on the balance sheet, which may suggest that the company is undertaking aggressive revenue recognition policies as it struggles to meet market forecasts; and deteriorating cash flow, which may indicate future problems being stored up by creative profit and loss accounting (it is harder to manipulate cash flow).

“Another issue to consider is the likelihood of a follow-on from previous warnings. Management may be too optimistic that a downturn in profitability is only short term – remember the old adage that ‘profit warnings come in threes’.

“More broadly, we worry when a management team is always just too optimistic.

“There may also be a heightened risk of a warning when a new management team is appointed. There is the temptation to ‘copper bottom’ the numbers when they can blame the old team for historic performance – and give themselves an easier start with profitability levels (on which to base their incentives).”

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Kirsty Desson, investment director, smaller companies equities, at abrdn, and fund manager of abrdn Global Smaller Companies

“As a rule of thumb, investors can enhance the long-term risk/reward ratio of their funds by investing in quality stocks. This means buying into companies with a clear and sustainable competitive advantage, a solid balance sheet and sufficient financial cushion to allow the company to weather different economic cycles, and a credible management team.

In doing so, investors can avoid stocks which may be more prone to earnings volatility. Many times, companies which have had a profit warning in the past, go on to disappoint again in the future.

“While profits warnings, by their nature, are unpredictable, there are a number of red flags which investors can monitor. Very simply, these can be divided into demand-related shocks and supply-related shocks.

“In terms of demand shocks, these can occur when there is a lack of visibility into the sales channel, for example where a company’s products or services are passed through an intermediary, such as an agent or distributor. In such cases, it can be difficult for management to have a true picture of end demand, leading to ‘overstuffing’ of the channel and subsequent collapse in orders as demand softens and inventory is unwound.

“Another common source of profit warnings is when a company has a high degree of customer concentration. If a customer decides to change its supplier, this can result in a sudden and material change in a company’s outlook.

“Similar to this scenario is when a company is involved in the supply of large, one-time projects or products, including short-term project delivery or the sale of large pieces of machinery. The timing of delivery is not always under management control and can materially influence quarter-to-quarter earnings, leading to profit warnings.

“On the supply side, flags to look out for include industry capex additions, and inflexible company cost structures.

“Cyclical stocks are particularly vulnerable to supply side shocks, as these stocks have limited pricing power. Industry players typically add capacity around the same point in the economic cycle, causing substantial swings in the supply situation and consequent price deflation.

“One last flag is high fixed-cost structures. In this instance, companies have less flexibility to manage fluctuating demand and diminished capacity to withstand demand weakness. Again, this can lead to profit warnings.

“In the end, investors can minimise the risk of experiencing a profits warning by focusing on quality stocks. Sadly, no model is 100% foolproof. For the most part, when a holding has announced a profit warning, we have exited.”