IN THIS ISSUE:

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• To succeed in the market you need to have a shot-gun and a rifle…
• Look out for the profit warnings spiral...
• By the time the third bell tolls – you'd better be out!

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From the pen of Karin Iten, managing editor, The South African Investor

Here at MoneyMorning, my aim is to help you become a better investor. I want to help you make money… And stop you losing it.

Over the past few weeks, I’ve looked at the secret of perfect diversification, how to overcome your investment mistakes, heck, I’ve even given you access to your ultimate stock market survival kit. I’ve spoken at length about investing techniques like 'take profit levels' and 'stop losses'. The latter can help you keep small losses from becoming big ones.

Today, I’d like to introduce you to a concept that my colleague, investment strategist, Bengt Saelensminde, calls “the three phases of profit warnings” – and show you how to be prepared for them. Over the years, Bengt’s found that profit warnings tend to fit a pattern. Spotting these bombshells early could save you a fortune.
 
The trick is to recognise the tell-tale language in company announcements… And today, we’re giving this trick to you…

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How to spot a hidden profit warning

By Bengt Saelensminde
 
Management can’t delay bad news forever. In the end the truth will out. But there are reasons why it’s better to drag the pain out by being economical with the truth.

That’s why management releases the pain in three instalments…

The first is to do with costs. When a company is struggling, the last thing it wants to do is admit it to its suppliers. Everyone from your stock supplier to the window cleaner will want his money upfront. Who’s going to give you nice credit terms if there’s any chance they might not get paid?
 
Large-scale suppliers normally insure themselves against a big customer going bust. But, every now and again, suppliers are told that they aren’t insured against a company not settling its bills. “Right”, say the suppliers. “It’s cash upfront for this job.” And if you’re already struggling, that’s the last thing you need.
 
The second reason bad news is held off is to do with sales. When you buy your groceries, you probably aren’t too bothered about the financial position of the store. But large corporations certainly do mind. Usually there’s a dedicated purchasing department, staffed with hard-nosed dealers this extract the best terms with suppliers.
 
If you’re the buyer and you want to renegotiate terms with your supplier, you’ll be in a much stronger position if he’s on the ropes.
 
Blurting out the extent of your business woes erodes your bargaining power with customers. So you try not to do it.
 
The third reason to downplay and drag out profit warnings is to do with directors. These guys don’t want to be seen to be presiding over a disaster story. And they certainly don’t want the share price trashed. Their bonuses are most likely linked to a buoyant share price.
 
To save face (and wealth), it’s likely directors will play down bad news and hope they can rescue the situation before things get worse and the share price gets trashed.
 
The problem is, bad news can’t be repressed forever.

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To succeed in the market you need to have a shot-gun and a rifle

No hunter worth his salt would use a shotgun to nail a trophy buffalo. Likewise, you wouldn’t try to bag a prize impala with a rifle. Well, the same goes for choosing the best shares on the market. Tailoring the proper tools to your specific goals is essential.

Fundamental analysis is like using a shotgun. By covering the widest area, you’re much less likely to miss the target. However, the tradeoff is you could mess up your timing spot. That’s why I recommend you also carry a rifle – and that’s where technical analysis comes in.

Generally, most investors are either on one side of the technical analysis debate or the other. But it makes the most sense to take both EARNINGS and EMOTIONS into account when making investment decisions.

Make sure you don’t ignore the technical by adding this tool to your investment arsenal today…
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Look out for the profit warnings spiral...
 
The first profit warning probably won’t even look like one. In fact, to the uninitiated, the phrasing of the news release will probably look like a jolly good little story.
 
But there’ll be a sneaky little sentence tucked away somewhere – a phrase laying the foundation for the second profit warning further down the road. I’m talking about a small suggestion that a cost is going up, or a particular market is ‘tough’ or ‘challenging’. It may be a technical issue that’s causing some difficulties and delays. “Not to worry” is the message – “we’re on top of things. Look at all this other good news!”
 
The point is that, in the release, there’ll often be more good news than bad.
 
That’s why you need to read company announcements at source and not via newspapers – you may miss the ‘real’ story. You can download regulated news releases (SENS announcements) from a reputable market source like I-Net Bridge.

View the first warning as a pre-amble, ready for the second warning which will nearly always come. And it’s the second profit warning that’s the biggy.

This comes after management have held off publishing the bad news for as long as possible. Now they have to admit the problem tucked away in the earlier warning is more serious. To continue to cover up, hoping for a recovery, could land management in serious trouble. If it all goes wrong, directors could be up on charges of fraud and deception.

This is the warning that’s really going to hit the share price. And that’s exactly why I think it’s usually best to dump the share at the first sign of trouble. That’s before the situation gets so bad that directors have to let everyone know what’s going on.

After the second warning, things are out in the open. Now the company will find out how competitors, employees, customers and suppliers react. Will the rats desert the sinking ship?

Depending on how this pans out, you may get a third profit warning.

By the time the third bell tolls – you'd better be out!

This is where you’ve really got to watch out. The last sort of business you want to be invested in, is one that’s caught in a vicious circle. That is a downward spiral where various stakeholders start to distrust the business and defect.

The way to think about profit warnings is that they come in three phases. It may take management ten releases before they get to the last phase. But the key is to try to look out for that first warning. Don’t rely on a newspaper to do it for you. Get hold of the release and look for any phrases that suggest the start of a more serious problem.

And for heaven’s sake, try to ignore any comforting words that they’re dealing with the problem and you shouldn’t worry. Consider the bad news – and decide whether you’re still comfortable holding the share. If not, get out.

Until next week… Here’s to your financial freedom and protection,

Karin Iten and Bengt Saelensminde