Why do financial markets overreact to bad news.? For example, in February, Tongaat Hulett issued a trading statement warning that headline earnings for its full financial year would fall 250%.
We thought the best way to investigate this problem was to look at profit warnings, those public moments that shine a light on corporate failings and pose that most fundamental question to investors of all types: should they buy, hold or sell? We polled 130 global institutional investors, representing over $8.4-trillion assets under management to ask them about their main drivers for responding to a profit warning. The primary individual reason listed was financial, with 28% of the overall vote, but not far behind were some surprisingly emotional responses.
The combination of a lack of confidence in management, the fear that more bad news is yet to come, and the pain of having been burnt in the past all come together to drive a highly emotional reaction to company news announcements. Moreover, emotional drivers heavily outweigh financial ones. And we think we have a good idea about why this is happening.
There is significant scope for companies to reduce the crisis multiplier by addressing issues of trust and confidence head on. That way, when a warning lands, reputational credit in the bank can act as a buffer to defend the share price and ultimately protect company value.