Cheap shares are sometimes cheap for a reason. Delving into a company's past can provide useful insight into its future.
Investors are always told to look forward and not back when buying shares. But when a reader recently wrote me extolling Character Group
(LSE: CCT)
I replied saying that I didn't like the shares because of the company's chequered past. On reflection, though, I wondered whether I should have been so scathing because of the company's past indiscretions.
Character Group, which buys licences to make merchandise such as toys and dolls, was a popular share among private investors in the nineties. For example, it won the rights to reproduce the figures in the Star Wars movie, which should have been a licence to print money. But the project turned out to be a major flop, and clearing unsold Star Wars merchandise forced the company to issue a profit warning.
Even a subsequent licence to merchandise the cartoon characters in Nick Park's film Chicken Run in 2000 failed to revive fortunes at the company. The "Great Escape" that Chicken Run was supposed to inspire failed miserably, as the company issued another profit warning. It was more egg on the faces of Character Group managers, and more holes in the pockets of shareholders.
But this time things are meant to be different. Character Group has won licences for merchandise relating to Dr Who, Gr8 Gear, Peppa Pig and Robotic. According to a recent trading update, the company said deliveries of toys and dolls to clients were completed on time. Consequently, it now expects results for the financial year to be ahead of expectations.
On the face of it there is a lot to commend the shares. Character Group is valued at 8 times prospective earnings, which is a 40% discount to the market. It is also valued at 0.4 times sales, which looks cheap. Additionally, its shares, which cost 75p a pop, are yielding 4.5%. And perhaps significantly, venture capital firm 3i
(LSE: III)
owns a 24% stake in the business.
But is its attractive valuation a trap for unsuspecting investors?
For instance there were lots to commended high street fashion retailer Forminster
(LSE: FORM)
, too. And look what happened there. The company once sported a low P/E, and yielded a mouth-watering 7%. But it went bust after losing a crucial agreement to sell Kookai clothing in the UK.
Of course, Character Group is an entirely different proposition to Forminster. One sells trendy clothes, and the other sell trendy toys. Hmm. But what really worries me is that the toys, games and giftware markets are notoriously fickle. And how many unsold Cybermen will end up back in Character Group's warehouse after Christmas?
Interestingly, the company had the two best-selling Christmas toys last year, which lifted the shares to a high of 80p. These were a Dalek from Dr Who and Roboraptor. Question is, can Character Group repeat last year's success?
If it can then the shares may climb to reflect the improved prospects of the business. But the downside of a poor Christmas is that its current low valuation could start to look expensive. All it takes is for one or two products to falter and profits, which are only expected to be £5m, may evaporate.
