How to go ‘bot­tom fish­ing’ for cheap stocks

The Daily Telegraph - Your Money - - YOUR MONEY -

Canny in­vestors can make a tidy profit by hook­ing shares in strug­gling firms, but it’s a risky business, warns James Con­ning­ton

Buy­ing a stock that is strug­gling in the hope of a re­cov­ery is not for the faint-hearted, but get­ting it right can be highly prof­itable. Mar­ket rises and falls are driven by hu­man emo­tion, which can cause over­re­ac­tion to bad news. This, in turn, can present op­por­tu­ni­ties.

How­ever, merely buy­ing a stock af­ter it falls be­cause it is cheaper isn’t enough of a rea­son to buy in it­self. There is noth­ing to say a com­pany whose share price has halved can’t suf­fer the same fate again. The dif­fi­cult part is find­ing a stock that is cheap but doesn’t de­serve to be and has the po­ten­tial to re­cover.

Si­mon McGarry, an an­a­lyst at wealth man­ager Canac­cord Ge­nu­ity, said: “So-called ‘ bot­tom fish­ing’ is in­vest­ing in com­pa­nies that are cheap be­cause of a problem with the com­pany it­self or the wider econ­omy – but based on the premise that the low val­u­a­tion is tem­po­rary.

“Of course, there is sig­nif­i­cant risk. The price is de­pressed for a rea­son, so it could stay lan­guish­ing at the bot­tom.”

Canac­cord has put to­gether a “screen” to iden­tify just these stocks – where in­vestors have “fallen over each other in their rush to get out” but where the out­look looks brighter than that sen­ti­ment.

It screened for three fac­tors: stocks trad­ing at a share price more than 20pc be­low their 12-month high, stocks whose earn­ings per share are forecast to grow over the next 12 months, and stocks on which an­a­lysts have raised their earn­ings fore­casts.

In to­tal 11 com­pa­nies fit­ted the cri­te­ria (see ta­ble), rang­ing from small min­ing firm Ken­mare Re­sources to to­bacco gi­ant Im­pe­rial Brands.

A screen such as this is only a start­ing point, rather than a list to go and buy. Each stock needs to be looked at and as­sessed.

We spoke to two fund man­agers who spe­cialise in spot­ting such “value” op­por­tu­ni­ties about their method for pick­ing a re­cov­ery stock and the po­ten­tial red flags.

Much of the in­for­ma­tion dis­cussed is eas­ily ac­ces­si­ble to the every­day in­vestor. On­line in­vest­ment shops such as Har­g­reaves Lans­down and data ser­vices such as Morn­ingstar can all be used to find val­u­a­tions, earn­ings and bal­ance sheets. On­line re­source In­vesto­pe­dia can help you get your head around the jar­gon.

How­ever, only a con­fi­dent, ex­pe­ri­enced in­vestor should con­sider buy­ing in­di­vid­ual stocks.

Will Lough, one of the man­agers of River & Mer­can­tile’s UK Re­cov­ery fund, said he looked for com­pa­nies fur­thest away from their five-year share price peak, with the low­est profit mar­gins for the past 10 years. He said the re­cov­ery po­ten­tial lay in the com­pany ex­pand­ing its mar­gins again.

He then looks to see if the stock is at­trac­tively priced ver­sus its his­tory. This can be mea­sured by the “price to book” ra­tio, which com­pares the


Imag­i­na­tion Tech IP Group Ken­mare Res Cairn En­ergy Serco Lad­brokes Coral Vir­gin Money Im­pe­rial Brands In­dus Gas Dig­nity Redde com­pany’s mar­ket value with the value of its as­sets, the price to earn­ings ra­tio, div­i­dend yield, and how much cash a business gen­er­ates per share ver­sus its share price (called the “free cash flow yield”).

Buy­ing the share at the right price is key, said Mr Lough. He wants to buy when the com­pany has al­ready started re­bound­ing from rock bot­tom, when earn­ings ex­pec­ta­tions have started to rise. “The idea is that you’re will­ing to miss out on the first 10pc of the re­cov­ery, but your in­for­ma­tion is bet­ter if you buy af­ter the share price has sta­bilised. It also shows that oth­ers are recog­nis­ing the po­ten­tial too and buy­ing,” he said.

Mr Lough added that there were two main red flags to avoid when it came to pick­ing a re­cov­ery stock. The first is avoid­ing “value traps”, which are cheap for a rea­son.

“For in­stance, if there has been a ma­jor change in the mar­ket that makes the firm ob­so­lete,” he said, high­light­ing the Black­Berry maker for­merly known as Re­search In Mo­tion, which has lost 93pc of its value since its 2008 peak.

“It had huge suc­cess, but in­vestors clung on to their past earn­ings, be­fore Ap­ple came along with the iPhone. The past isn’t nec­es­sar­ily a good frame­work for fu­ture prof­its if there has been a struc­tural change.”

The sec­ond red flag is a com­pany that has too much debt on its bal­ance pe­riod. He also thinks the bal­ance sheet is im­por­tant to de­ter­mine whether the com­pany has the ca­pac­ity “to sur­vive.”

“We ask if it’s a spoof – a com­pany’s prof­its over the past 10 years could be skewed be­cause they sold a di­vi­sion, for in­stance. Then we ask if there are any sus­tain­abil­ity or gov­er­nance is­sues that mean its next 10 years will de­vi­ate from the av­er­age too,” said Mr Adler.

For in­stance, he ex­plained that the min­ing sec­tor came on to his screen sev­eral years ago, but he didn’t in­vest ini­tially. In­stead he viewed the past 10 years as an ab­nor­mal pe­riod in the sec­tor’s his­tory, and so not a fair rep­re­sen­ta­tion.

One other red flag for Mr Adler is if a com­pany’s profit mar­gins are out of line with its ri­vals.

He said: “If a business has a 10pc mar­gin but all of its com­peti­tors in the UK and glob­ally have a 5pc mar­gin, it’s likely to be un­sus­tain­able.”

Two un­pop­u­lar sec­tors the value team are cur­rently in­vest­ing in are re­tail firms and banks. “Many peo­ple have given up on banks, but the bal­ance sheets are stronger than ever, and the op­por­tu­nity for in­creased earn­ings is in­cred­i­bly sig­nif­i­cant,” Mr Adler said.

‘It is in­vest­ing in com­pa­nies that are cheap – but only tem­po­rar­ily’

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