Four key lessons from Provident Financial’s 70% share price drop

Provident Financial Neil Woodford

Shares in Neil Woodford favourite Provident Financial (LON: PFG) (PFG.L) have taken an absolute beating this week, falling around 70% on Tuesday after releasing another profit warning. The shares have recovered slightly in the last few trading sessions, yet remain a long way below the 3,200p level they were trading at in May.

The switch from self-employed debt collection agents to company employed ‘Customer Experience Managers’ has backfired in a big way, and management now expects the consumer credit division to incur a loss of £80-£120m during 2017, down from the £60m profit forecast in June. Chief Executive Peter Crook has stepped down with immediate effect.

I’m not a holder of Provident, although I have been watching the stock with interest recently, as it has been a solid dividend payer in recent years. So are there any lessons we can learn from the fall? Absolutely! Here’s a few of them.

Even the pros get it wrong sometimes

It’s no secret that Neil Woodford has a large holding in Provident. Indeed, the fund manager owns almost 20% of the shares in the sub-prime lender, and has significant positions in both his Equity Income and his Income Focus funds. You can read Woodford’s take on the situation here.

The lesson here? Even top professional portfolio managers occasionally get their calls wrong. For this reason, it’s important to not blindly follow portfolio managers into stocks. Always do your own research.

Diversification is essential

Next, always diversify. This is pretty obvious, but if you own 30 stocks and one bombs by 70%, your loss is only around 2.33% of your portfolio. In contrast, if you only own five stocks and one falls by 70%, your loss is 14%. Diversification is a fundamental risk management concept, yet it’s amazing how many investors fail to diversify properly. One way of diversifying a small portfolio is to add index funds, investment trusts or mutual funds to the portfolio.

Dividend cuts are lethal

In relation to the dividend, Provident stated:

“In view of the substantial deterioration in the trading performance of the home credit business, together with the uncertainty created by the FCA’s investigation at Vanquis Bank, the Board has determined that the group must protect its capital base and financial flexibility by withdrawing the interim dividend declared on 25 July 2017 and indicate that a full-year dividend is unlikely.”

When a company unexpectedly cuts its dividend, it never ends well. Many investors exit the stock and the share price usually falls significantly. It’s no different here. For this reason, it’s important to do your research into the sustainability of a company’s dividend payout. That brings me to my last point.

Watch the dividend coverage

In recent years, dividend coverage at Provident Financial has hovered around the 1.30 mark. Last time I reviewed the stock, coverage for FY2017 was forecast to be 1.17 times. That’s a relatively low level of coverage, and one reason I haven’t bought the stock in the past. The higher the coverage the better, and a ratio of 1.5 is less than ideal, as it suggests that there’s not a lot of margin for error if profitability falls. Buying dividend stocks that don’t have adequate levels of dividend coverage is a mistake that many investors make. Always check a stock’s dividend coverage before you invest for the dividend.

Disclosure: Edward Sheldon, CFA has no position in Provident Financial. 

This article is provided for general information only and is not intended to be investment advice. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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