Warnings investors should note; The Investment Column

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The Independent Online
One of the hardest things for investors is to admit they got it wrong and cut their losses. It is so tempting to look at a flagging share and believe another 20p or whatever will bring you back to the price you paid - before you know it the share has fallen another 50p and rather than facing up to a pounds 200 loss you're getting in a flap about a pounds 700 hit.

Drawing a line under the investment then becomes that much harder, so you hold on in the vain hope that things will get better. Finally, you bite the bullet and take a loss maybe four or five times bigger than you should have done.

This startled rabbit effect is clearest when a company unexpectedly issues a profits warning. The shock of seeing 40 or 50 per cent wiped off the value of your investment in one day renders you incapable of thinking clearly about the situation and a small bounce the following day is often enough to persuade you that the market has over-reacted. Sometimes it has, but take a look at the charts below. More often these days a profits warning is just the beginning of the bad news.

In recent months there has been a spate of warnings of this sort. Matthew Clark is one of the clearest examples - 670p one day, 430p the next, 306p 10 days later. But there have been plenty of others - Inspec down 29 per cent in two weeks, First Information Group down 87 per cent in three weeks, Stratagem down 29 per cent in two days.

Tilney & Co, the Liverpool-based regional broker, has studied a raft of recent profit warnings in search of themes. Obviously, with such a range of companies, the picture is rather complex, but a number of strands have emerged.

The first common feature of recent collapses has been the sheer scale of the fall and the fact that it tends to continue for many trading days before turning into a gentle downward drift. In the past, share price tumbles tended to be tempered by contra-thinkers who moved into the market and took the edge off the downward pressure. Bottom fishers are far less in evidence now.

Secondly, there seems to be a preponderance of dramatic falls among highly rated but poorly understood hi-tech or biotech companies. The technical knowledge required to understand many quoted companies these days has simply moved out of the orbit of most investors. They become mesmerised by exponential growth prospects and panic when the wheels appear to come off.

But plainly such an explanation does little to answer why the market is punishing companies like the cider maker Matthew Clark so harshly. In situations such as this, where investors have a good understanding of the dynamics of a business, Tilney believes the explanation has more to do with the current high level of the market. At around 4,000, investors are uncomfortable and desperate to be in "quality" stocks when the music stops. By definition, a company that warns on profits is not "quality" and investors run for the exit.

So what should you do in the unfortunate event that one of your investments goes sour? First, forget the old stock market advice that you should never panic - get out as quickly as you can. You will miss out on some rebounds, but in many more cases you will avoid further declines. In Tilney's words, profits warnings, like buses, often come in threes - selling after the first will often look sensible by the time the third comes along.

Second, with the market riding high, look for quality. Relatively low price-earnings ratios provide a cushion if your investment rationale hangs on a high prospective growth rate. Make sure your company's earnings are backed up by strong cash flow, which is much harder to fudge. Finally, avoid shares which are underperforming the rest of the market, even by a small amount - the lukewarm attitude of investors could well be an early sign of bad news around the corner.