People may be wary of buying a cheap car or even a cut-price haircut. But many investors seem almost obsessed with the hunt for cheap shares.
But are cheap shares the bargain they might seem? The answer is sometimes yes and in other cases no. Here are four different reasons shares might be trading for what seems like a low valuation – and what that can mean for my decisions when investing my money.
Declining demand
Buying a share is like buying a claim on a proportion of a firm’s future profits. If a company is heavily concentrated in an industry likely to face long-term declining customer demand, that can affect its valuation.
I think that helps explain the prices of British American Tobacco and rival Imperial Brands. Both have declined markedly over the past five years. In the past year though, British American has fallen by 2%, but the Imperial share price has moved up 18%. Are these cheap shares – or value traps?
The answer may lie in how much profit they can continue to make from cigarettes as smoking declines in popularity, along with whether the firms can successfully diversify into alternative revenue streams.
Competitive threat
Even in an industry that is not declining, the threat of more competition can hurt a company’s valuation. Indeed, a large industry with big growth prospects is exactly where I would expect to see competition heat up.
That can help explain why apparently cheap shares such as discount retailer B&M get cheaper. It has fallen 20% over the past year and now trades on a price-to-earnings ratio of 12. Whether that is an attractive entry point for my portfolio or not will partly depend on what stiff competition in the retail sector means for B&M’s profitability in coming years.
Questionable future
Some real bargains can be found among struggling companies that many investors have already written off as dead.
But investing in what seem like walking zombies can also lead to losing all of an investment when they actually do die. That existential risk needs to be weighed against the potential reward of a company priced for failure actually coming back from the brink.
I think that describes the current situation at Cineworld. If it restructures its debt and business returns to normal, the cinema operator could turn out to be a huge bargain at today’s share price.
But I actually consider Cineworld as overpriced and not cheap shares, so will not touch them with a bargepole. I see a significant risk that the shares will go to zero. Management has repeatedly flagged this risk too.
Unpopular industry
Some industries are in long-term structural decline, like tobacco (although that process can last for decades, with vast profits made in the meantime).
But other industries simply fall out of fashion with investors. Sometimes these are cyclical industries, such as mining and oil. Buying into an unfashionable industry when it is at a low point in its pricing cycle can be very profitable when prices go up again and take profits with them.
So when looking at potentially cheap shares from an unfashionable industry, as an investor I consider whether that unpopularity is likely to be a temporary phenomenon — or a permanent one.
