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 lifer 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 being 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 that 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 spend 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 comes 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 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.