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We look at examples of stocks that are cheap for a good reason
Thursday 23 Aug 2018 Author: Lisa-Marie Janes

People are always looking for bargains, whether they are shopping for shoes, a dream holiday or even stocks and shares.

However, some companies trade on cheap valuations for a reason, and even if their discounted rating is unwarranted a catalyst is required to unlock this value. Stocks which are justifiably cheap, or lack catalysts can be called ‘value traps’.

DEBENHAMS: CHEAP FOR A VERY GOOD REASON

One of the most high-profile fallers on the stock market this year is embattled Debenhams (DEB). The department store chain recently downgraded annual pre-tax profit guidance from £50.3m to between £35m and £40m following underwhelming trading.

This is not the first warning in recent history. But is all the current bad news priced into the shares? After all, the future earnings trajectory is upwards, according to analysts and so some investors may see good value in buying the shares now.

Pre-tax profit is expected to rise from a forecast £34.7m in the year to 31 August 2018 to £37.1m in 2019 and increase further to £41.1m in 2020.

Debenhams plans to turn its fortunes around by becoming a leader in ‘social shopping’ and simplify its operations with store and warehouse closures.

There are certainly reasons to look closer, yet Liberum analyst Adam Tomlinson categorically states that Debenhams is a value trap. His study of the company’s situation implies that earnings may not be strong enough to keep paying dividends at the current level.

The shares are currently trading on a prospective 4.6% yield. Looking at forecasts published on Reuters, the company is expected to report £15.6m negative free cash flow for the year to 31 August 2018, so the dividend is uncovered.

Tomlinson says high operating leverage reflects ‘very high sensitivity of earnings’ to changes in sales, while its new strategy is not feeding into its financial performance.

You also have to consider that it has an average 18 year store lease and £4.5bn of lease commitments.

Debenhams trades on a low 6.1 times forecast earnings per share but its myriad problems and stalling strategy do not suggest the stock is good value. This is definitely one to avoid.

HIGH YIELDS OFTEN TELL YOU SOMETHING IS UP

Trading on an exceptionally low 2.8 times forecast earnings per share for 2018 and offering an 11.5% dividend yield, newspaper publisher Reach (RCH) is also a stock to avoid as we rate it as a classic value trap.

The owner of Daily Mirror and Daily Express has been struggling to drum up sales and profitability over the last decade despite three major acquisitions and extensive cost cutting.

‘When a stock’s dividend yield is higher than its forward price to earnings ratio, this is usually the market’s way of politely telling analysts their earnings and dividend forecasts are too optimistic – or telling the company it is dying on its feet,’ comments AJ Bell’s Russ Mould.

The investment director warns that Reach’s recent £150m write-down in the value of some of its assets suggests its portfolio of local papers is not worth as much as management previously thought.

Reach, previously called Trinity Mirror, has traded on an ultra-low PE for several years and market perception of its industry being in terminal decline and substantial pension liabilities means it is hard to see this situation changing.

IS PETS AT HOME A VALUE TRAP?

Another potential value trap is pet pampering specialist Pets at Home (PETS) as jitters over competition and subdued consumer confidence weigh on its valuation.

Pets at Home trades on 8.9 times forecast earnings per share for the year to 31 March. That’s cheap, but cheap for a good reason.

In a bid to revive the business, Pets at Home is cutting prices and doing more promotions, which generated 6.1% like-for-like sales growth in the 16 weeks to 19 July.

Another key issue is a shortage of veterinary practitioners needed to help run the company’s vet practices.

Liberum speculates free cash flow will decline by 28% in 2019 and a further 22% in 2020 amid a need for greater working capital to support the vet practices.

Unfortunately, the broker is not confident that Pets at Home can hold up against relentless rivals, leading to potential downside risks.

Shore Capital’s Phil Carroll sees Pets at Home’s 45% share price decline since last September to 121.8p as a buying opportunity.

He believes the company’s devaluation has been harsh; flagging the transformation plan appears to be working with some profit growth expected year-on-year.

FRENCH CONNECTION: LOTS OF CASH BUT IS THE BRAND STILL RELEVANT IN TODAY’S WORLD?

While French Connection (FCCN) has been losing money for years thanks to a weak retail operation, analysts believe it will make a breakthrough in the year to 31 January 2019 with £0.9m pre-tax profit. That’s despite an anticipated decline in sales from £154m to £144m.

A big step in the right direction for the fashion retailer was the sale of its Toast mail order business for £23.3m, helping to support its working capital and potentially supporting a resumption of dividends.

Net cash is estimated to be £24m at the end of the current financial year, equal to half its market cap, so there is clearly some interest to value investors.

But is this really a company you’d want to own when the alternatives on the stock market such as many of the online fashion retailers are far more attractive? Yes, the latter trade on high valuations but that is justified by far superior growth and the fact they are sitting in the right part of a structural growth trend (namely the shift online).

Nonetheless, French Connection isn’t a stock to write off completely. While the retail arm is struggling, the wholesale business is much more interesting. This is probably the value trap-style stock to watch closely. (LMJ)

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