Why now is a great time to look at ultra-cheap shares
In this article we take a dive into the lowly valued part of the UK stock market to see if we can find some hidden gems. Specifically, we are looking for shares trading on less than eight times forecast earnings.
It is sometimes said ‘one man’s meat is another man’s poison’ or ‘one man’s rubbish is another man’s treasure’.
Digging around the ultra-cheap end of the stock market may not be everyone’s cup of tea, but it may yield some real bargains.
Another reason to take a closer look is that cheap shares have come back into fashion. Rising interest rates and rampant inflation have resulted in a savage underperformance of growth stocks trading on premium valuations.
WHY DO STOCKS TRADE ON DIFFERENT VALUATIONS?
Despite its reputation as a relatively blunt metric, the humble PE or price to earnings ratio is more useful than you might think.
An academic paper written by Marty Leibowitz and Stanley Kogelman in 1990 that appeared in the Financial Journal of Finance provided a better understanding of the factors that drive the PE ratio.
In 2004 Leibowitz put his ideas into a book, Franchise Value: A Modern Approach to Security Analysis.
One of the surprising results from the analysis is the extraordinary magnitude of growth required to raise the PE significantly.
For example, to justify a PE ratio twice that of the market, a company would need growth opportunities equivalent to five times its current earnings. That is a lot of growth.
The growth also needs to be profitable with return on equity above the market average. In other words, unprofitable growth doesn’t add to shareholder value.
But the useful part is the Leibowitz model allows investors to convert estimated earnings growth into a theoretical PE ratio. It can also be used to calculate the implied growth of companies trading on different PE ratios.
For example, Microsoft (MSFT:NASDAQ) trades on a forward PE ratio of 25.8 times and generates a return on equity of around 40%.
This PE implies the company can grow its earnings by around 12% a year for the next decade. If delivered, earnings per share in 10 years would be three times higher than the current level.
It is worth highlighting that some sectors regularly trade at a discount to the market. The Leibowitz model suggests these companies are growing less than the market or are in structural decline.
A lower than market PE can also reflect extra investment risks such as high earnings fluctuation (uncertainty) and weak finances (higher than average debt).
Banking shares traditionally trade on a discount reflecting the cyclicality of their earnings, high leverage and low growth. Earnings progression is crimped by the regulator which determines the minimum amount of capital the banks require to support their business growth.
Resources firms often also trade at discounted valuations to reflect how their earnings are linked to volatile commodity prices.
The FTSE 100 index trades on a forward PE ratio of 14.3 times according to Stockopedia data and earnings are expected to grow 8.5%. The FTSE All-Share trades on 13.7 times for similar growth.
Shares has used Stockopedia data to search for companies with a forecast PE below eight times – restricting our search to companies with a market cap of at least £100 million.
These shares are generally unloved and investors by implication believe they are structurally challenged from a growth perspective or likely to be unprofitable over the coming years.
Russian gold miner Polymetal (POLY) and Ukrainian iron ore outfit Ferrexpo (FXPO) both feature in the table because their valuations have been heavily impacted by external factors – namely Russia’s invasion of Ukraine.
The trick is to spot companies where the problems can be easily fixed or where investors have failed to recognise the growth potential.
Even a modest growth outcome can be rewarding if it is accompanied by a re-rating of the shares (investors pay a higher PE). Let’s look at an example to see how this works.
Business services company Kier Group (KIER) trades on an ultra-low PE of 4.7.
If we play devil’s advocate and assume the company achieves modest growth of around 2% a year and delivers a return on equity of 9%, investors should be theoretically willing to pay a PE of around 14 times, equivalent to the market PE.
Under this theoretical scenario earnings over the next 10 years grow from 15.9p per share to 19.4p per share (because of compounding the total growth is slightly higher than 10 times 2%).
Applying a multiple of 14 times would result in a share price of 271p. That would equate to a shareholder return of 13.1% a year. [MGam]
Three single-digit PE stocks to snap up
Synthomer (SYNT) 299.5p
Forward PE: 7.4
Over the last six months shares in plastics manufacturer Synthomer (SYNT) have fallen by 40%. This de-rating has been due to margins in its NBR (nitrile-butadiene rubber) business normalising at a faster rate than management had anticipated after an exceptional 2021.
From a valuation perspective the shares now look attractive given the encouraging first quarter trading update.
NBR supplies nitrile latex for medical gloves. During the pandemic, Synthomer experienced continued sustained demand for these gloves, which are used extensively in hospitals and other segments of the medical sector, due to their high strength and superior puncture resistance.
However, when the Covid pandemic receded, demand slowed at a faster rate than had been anticipated. This resulted in a reduction in earnings forecasts.
The NBR part of the group is expected to return to growth in the second half of this year and Numis expects earnings per share as a whole to increase by 21% from 2022 to 2023.
The current forward PE looks too cheap relative to the anticipated resumption of growth. [MGar]
Rio Tinto (RIO) £56.44
Forward PE: 5.8
Mining giant Rio Tinto (RIO) faces several operational and cultural challenges plus the prospect of weaker metal prices in the short term.
However, we think its new boss Jacob Stausholm can tackle these issues head on and in that context the price does not reflect the scope for a turnaround in its fortunes.
Jefferies analyst Christopher LaFemina expects iron ore output to increase through the course of the year with aluminium and copper also benefiting from ‘improved operational performance’.
We also think market sentiment should improve towards Rio as Stausholm shows he is addressing the toxic workplace culture revealed in a bombshell report released in February.
Given long-term demand for the metals extracted by Rio is likely to be underpinned by the transition to renewables and electric vehicles, a price to earnings ratio of less than six times looks far too low.
And while investors wait for this value to be unlocked they are being rewarded with generous dividends – Jefferies forecasts a payout worth more than $10 billion for 2022. [TS]
Vertu Motors (VTU:AIM) 51.2p
Forward PE: 3.2
While the outlook for spending on big ticket items such as cars is uncertain, a grudgingly low price to earnings ratio fails to reflect the value under the hood at Vertu Motors (VTU:AIM), the UK’s fifth largest automotive retailer trading as Bristol Street Motors, Vertu and Macklin Motors.
Steered by CEO Robert Forrester, the cash generative car retailer with strong property asset backing has returned to the dividend list after a Covid hiatus. It also continues to play its part in the consolidation of the fragmented UK automotive retail market, taking share through acquisitions supplemented by organic growth.
Vertu’s recent upgrade cycle has been driven by sector tailwinds including severe vehicle supply constraints coming out of Covid, which has boosted new and used car prices, with acquisitions also adding some fuel.
Consumer confidence could come under pressure, but demand remains strong for now and we see established omni-channel operator Vertu as a future winner, having offered full online sales of used cars ahead of anyone else back in 2017. [JC]
Cheap for a reason: a low PE stock to avoid
N Brown (BWNG:AIM) 29.4p
Forward PE: 4.1
Online clothing and footwear retailer N Brown (BWNG:AIM) has been a perennial market underperformer.
Despite positive changes made to sharpen its focus and reduce debts, we believe an uncertain consumer backdrop is likely to stymie further progress.
The shares have looked cheap at face value for a long time, but the fundamentals of the businesses do not look strong enough to support a recovery in the near term.
Analysts have consistently revised down their earnings expectations over the last 18 months according to Stockopedia data.
More recently (3 Mar) the company warned soaring inflation and rising costs will crimp earnings in the year to February 2023, prompting further significant downgrades.
Although the company is taking mitigating actions the need to continue investing to grow key brands will put pressure on margins.
These actions are designed to boost growth in the firm’s five strategic brands – Ambrose Wilson, Home Essentials, Jacamo, JD Williams and Simply Be – and offset declines in legacy brands. [MGam]