How to go ‘bottom fishing’ for cheap stocks
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
ARE THESE COMPANIES READY TO REBOUND? Company
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’