How to profit from profit warnings

Small cap investors can make good profits from earnings downgrades … here’s how.

Summary: Investors can make good money short selling companies that have issued a profit warning. Short selling is the process of selling a borrowed stock with the aim of buying it back later at a lower price to profit from the difference.
Key take-out: The best gains may come from the first 30-days after the profit warning, but these stocks can continue to lag the market for months after.
Key beneficiaries: General investors. Category: Growth.

Hearing cheers as our market hits new 5½-year highs must grate on some nerves. While Australian equities have rallied hard over the past few months, some parts of the market feel like they are stubbornly ensnarled in a bear trap.

The trouble is that the wave of profit warnings from resources-related companies has created a very lopsided rally. Small cap investors who are overweight on these stocks will be nursing losses of around 20% on average since the start of the calendar year.

But there’s good news. There is a way for investors to profit from profit warnings, and the strategy looks well suited for the times as more profit downgrades are probably on the way.

While this confession season (May and November are months where companies typically provide trading updates) is not as bad as last year’s, WilsonHTM Investment Group calculated that this May is one of the worst for junior resource stocks.

S&P/ASX Small Ordinaries Index

ASX Small Resources Index

Source: WilsonHTM Investment Group

“The downgrades now are to 2013 earnings,” said WilsonHTM strategist, Damien Klassen. “When we actually get to reporting season (in August), analysts will focus on 2014 earnings and realise that they are way too high.”

Investors can make good money short selling companies that have issued a profit warning, and the strategy is not as risky as some might believe. Even if you shy away from short selling, there are some important lessons on how to survive confession seasons that are covered at the end of this article.

Short selling is the process of selling a borrowed stock with the aim of buying it back later at a lower price to profit from the difference.

Macquarie back-tested this strategy by looking at the performance of companies that have issued profit warnings since September 1998.

The broker found that if you had short sold these stocks for 20-days following the bad news, you would have made an annual return of 6.7% with a Sharpe ratio of 1.25. Sharpe ratio measures the risk-adjusted return, and a ratio of 1.25 indicates that the returns from the short sale did not come as a result of an investor taking on excess risk.

In fact, risks seem fairly well contained. While the probability of the trade going in your favour is 57.1%, the maximum loss on wrong-way bets is a fairly modest 7.8%, according to Macquarie.

Macquarie’s model was tested mainly on large cap stocks. The potential gains from using the strategy on small caps appear to be a lot more attractive.

I randomly selected 10 junior industrial companies that issued a profit warning last May and found that for every $100 you spent shorting the stocks (assuming you shorted them equally), you would have gotten back $164 in the 30 days following the warning.

Nine out of 10 of these stocks underperformed the ASX All Ordinaries Index, and the one wrong call would only have costed you half a percentage point in performance.

What is more interesting is that the underperformance of the group seems to be fairly protracted. Even if you held the short position opened for 120-days, you would still be able to generate a 180% return over that short period.

Also, at 120-days, all 10 of the stocks underperform the broader market.

Is it too late to use this strategy given we are closer to the end of this confession season than the beginning? The answer is probably “no”.

The best gains may come from the first 30-days of the profit warning, but these stocks continue to lag the market for months after.

If I short sold these stocks a month after the disappointing news, I would still generate positive alpha (returns above the market) of 44% in the next 20 days. The alpha falls away to 31% and 29% in the following two and three months, respectively.

Not quite as good, but not too shabby either.

While it is true that the sample size is small and mining engineers (this group has been under pressure for some time now) are over-represented, I still suspect small caps will make better candidates to use the strategy on because they are harder hit when investors lose confidence in management.

Further, small companies have fewer levers they can pull to right the ship due to limited resources compared to their larger rivals, and the lower liquidity for small stocks is another contributing factor.

One good shorting candidate is temporary accommodation and caravan manufacturer Fleetwood Corporation (FWD) after it said that earnings are likely to come in around 30% below consensus forecasts.

Eureka Report had written favourably about the stock before, due to its good management team and track record, but I suspect Fleetwood will lag the market for some time yet.

For one, the stock still trades at a premium to other mining-exposed contractors even after the more than 30% collapse in its share price. The stock is on a 2013-14 price-earnings multiple of around 10 times, when many other contractors are on a P/E that is closer to five times.

I do not think Fleetwood deserves to be on a premium as supply of accommodations at mining camps are likely to outstrip demand for the foreseeable future. 

Things also do not bode well for Fantastic Holdings (FAN) as the seasonal sales uplift it used to experience in March and April has failed to materialise this year.

As a result of this and costs associated with its strategic review, the furniture retailer is expecting a net profit of between $13.5 million and $15.5 million for the current year, compared with the $21 million it made in 2011-12.

Fantastic will probably not be able to keep pace with the broader market in the coming months because a turnaround in its business isn’t immediately evident.

What also concerns me is that the market has been blindsided by the news, with the stock recording a one-year gain of 18% prior to Monday’s shock warning.

Further, the profit drop of around 30% is the worst in the company’s history and I would like to see a clear pick-up in household formation before becoming more positive on the stock.

What is also interesting is that its peer Nick Scali (NCK) told Eureka Report that the industry isn’t in as bad a shape as what Fantastic’s profit warning might suggest.

I know it’s quite a bit to digest, but if you don’t remember anything about this story, you should at least keep the following key lessons in mind.

  1. Portfolio approach – don’t just short one or two “sinners”. You can control risk better if you short sold a number of stocks that have issued a profit warning.
  2. Performance prior to profit warning – short selling a stock works best if the market has not priced in the profit warning, although stocks that have already been de-rated will likely continue to underperform the market if the timing of their recovery remains uncertain.
  3. Go long on the market – it’s generally a good idea to hedge your basket of short candidates by “buying the market”. If your stock portfolio is heavily correlated to the ASX All Ordinaries index, you probably don’t have to do much else (assuming the capital used to short the stocks is modest). Another way to go long on the market is to buy a stock index exchange-traded fund (ETF). Having a long position is more important for those wishing to hold open their short positions for more than a few weeks.
  4. Stand and fight, or run? This is a question shareholders always ask themselves following a profit warning. It is not an easy question to answer, but history has shown, on balance of probability, you are better off selling the stock and buying it back when the dust settles.
  5. Don’t rush for bargains – there is a temptation to have a sniff around a stock after a painful sell-off. While there are probably good value buys to be found, small cap investors can well afford to take their time.

Happy hunting!

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