2 reasons I’m not backing a recovery in these cheap UK shares

Stock market volatility continues to offer up investing opportunities. However, I think some cheap UK shares may fail to recover and reach new highs.

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Global economic turmoil over the past year has been reflected in extreme stock market volatility. This has created a situation where there are now some really cheap UK shares out there.

One UK company whose stock is now trading very cheaply is boohoo (LSE:BOO), which is down an incredible 80% from its all-time high of 413p a share set two years ago. Indeed, the stock currently has a price-to-sales (P/S) ratio of around 0.4, which on the face of it is incredibly inexpensive.

Yet there are two reasons I still don’t see boohoo as a compelling bargain buy for my portfolio today.  

Limited pricing power

Pricing power is a company’s ability to raise prices for the goods and services that it provides. It is a hallmark of any strong business and enduring brand, as well as any successful investment over time. Indeed, legendary investor Warren Buffett has described pricing power as ”the single most important decision in evaluating a business”. It is particularly important when inflation is running high, as it is now, because companies with pricing power can preserve profit margins even while input costs are rising.

Unfortunately for boohoo, it doesn’t seem to have much in the way of pricing power. And inflation is starting to bite at the company. In its most recent trading update, management revealed that pre-tax profits for the 12 months to the end of February 2022 were down to £7.8m from £124.7m a year earlier. That’s a 94% drop!

Yet management has indicated that it is trying to prevent price increases to maintain the company’s competitive market position. This could damage boohoo’s balance sheet moving forward.

Intense competition

Speaking of boohoo’s competitive position, it should be noted that it now has an absolute juggernaut of a competitor in the international fast fashion space. That company is Shein, the Chinese online retailer, which has emerged almost from stealth mode to become the most downloaded app in the USA today, ahead of TikTok.

Shein remains a private company, so we still don’t know all the ins and outs of its operations. Yet some numbers we do know – and they’re very large. According to Morgan Stanley, Shein may post $20bn in revenue for 2022. In a funding round in April this year, Shein raised between $1bn and $2bn at a valuation of $100bn. That’s around 120x larger than the current market cap of boohoo, which stands at just £850m!

Down but not out    

Yet, despite its share price collapse, boohoo is far from a broken business. Sales rose by 14% year-over-year to nearly £2bn and have stayed above pre-Covid levels. Additionally, Citadel — one of the world’s largest hedge funds — has taken a 5% stake in boohoo, which suggests that certain big players are betting that the shares have bottomed out.   

Even so, I think the competition boohoo faces is formidable and its pricing power is weak. So I’m steering clear of these cheap shares and won’t be adding them to my portfolio.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be considered so you should consider taking independent financial advice.

Ben McPoland has no position in any of the shares mentioned. The Motley Fool UK has recommended boohoo group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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