To say that the latest profit warning from Tesco came as a shock is an understatement. A 16% fall in the share price that was already 44% down on its high was a clear measure of the surprise contained in this news. More tellingly it is also a powerful demonstration of the limitation of active management.

Active managers claim that only by detailed analysis of the accounts, and interrogation of executives, can the true prospects for a company be discerned. This approach is questionable if even management were unaware that their profits were at least 10% adrift of expectations. The notable thing here is that it is profits that are being questioned, not obscure details in the balance sheet. To be so far out in the estimate of profits suggests that there were issues all along the line in revenues and costs.

Perhaps even more perplexing is that analysts, on both the buy and sell side, underestimated the stresses that were building up under the pressures of increased competition, weak disposable consumer income and a ballooning balance sheet. Did they not expect these forces to translate into lower profits? The sharp reductions in forecasts after the announcement shows just how much analysts rely on management guidance for their forecasts.

Tesco though is not unique in shocking investors by saying business is tougher than the market thought. The list of companies that have recently seen sharp falls in share prices after warning about profits includes; Tate & Lyle, Petrofac, ASOS, Aveva, Charles Stanley, Afren, Xaar, Aggreko, Pearson, Admiral, Spirent and Aviva.

Active managers can of course point these events out to advocates of the Efficient Market Theory (the idea that the market incorporates all knowledge) and say that they demonstrate that the market is not so perfect after all. While that is evidently true it also raises the question of what value the 23 sell-side analysts that follow Tesco have added. It is not so much that active managers are wrong, rather that there is precious little reward for all that effort and work.

Contrast that with the passive manager who accepts the rough with the smooth. He might end up with a similar return but gets there with much less effort and that means lower cost. Active managers that are on the ball and underweight troubled stocks before they fall will do relatively well. It is clear though from the price response…

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