I love to buy cheap shares. But I know that investing in the wrong kind of cheap share can be an expensive mistake.
Today I’m going to look at two cheap stocks which have particular problems. Are the potential rewards worth the risk of a big loss, or is the only sensible option to stay away?
Cheap and profitable
Hogg Robinson Group (LSE: HRG) provides businesses with outsourced services such as travel and expenses management. The group has an operating margin of about 12% and generates plenty of free cash flow to support its 3.7% dividend yield. In my view, it’s a good quality business.
The firm’s shares currently trade on a forecast P/E of nine, even though earnings per share are expected to rise by 17% this year. In theory, Hogg Robinson should be a straightforward value buy.
The problem is that the firm’s balance sheet is loaded down with huge pension liabilities. Hogg Robinson’s pension deficit rose from £258.3m to £413.2m during the six months to 30 September.
To put that in context, £413.2m is nearly double the group’s market cap of £226m. So even if Hogg Robinson was sold and the money paid into the pension fund, there would still be a big shortfall.
The value of the pension deficit is linked to corporate bond yields, which fell sharply last year. If this decline reverses then the pension deficit could shrink rapidly — the company says that a 1% increase in bond yields would reduce the deficit by £162m.
Unfortunately, there’s no guarantee this will happen. The situation could still get worse, especially if inflation continues to rise.
The worst-case scenario for shareholders is that Hogg Robinson will end up being run solely to generate cash for its pension fund. The dividend could be stopped and the value of the shares would fall dramatically.
There’s no way of knowing how things will turn out. So the shares look pretty risky to me.
I couldn’t do it
Trinity Mirror (LSE: TNI), which owns the Daily Mirror, also has a problem pension.
The group’s pension deficit rose by £160m to £466m during 2016. Like Hogg Robinson, Trinity Mirror now has a funding shortfall that’s bigger than the business itself, which has a market cap of £319m.
However, there’s an extra complication here. Most people believe that the printed newspaper business is in long-term decline. Trinity Mirror’s like-for-like sales fell by 8% last year.
Although the group boosted its overall revenue by 20.3% through the acquisition of regional group Local World, there’s no disguising the problem. Digital readership is growing but the income from online activities isn’t replacing lost revenue from print newspapers.
Despite this, the company is currently very profitable. By cutting costs, combining operations and selling unwanted assets, Trinity Mirror is making money. The group generated an operating profit of £93.5m on sales of £713m last year. That gives an operating margin of 13%, which is pretty good.
Trinity Mirror’s 2017 forecast P/E of 3.3 tells me that the market thinks this story is going to end badly. I share this view. But there is just a small chance that the market view is wrong. If the group’s management can put it onto a sustainable long-term footing, the shares could deliver big gains from current levels.
