One of the challenges of buying ‘cheap’ shares is trying to decide whether they really are cheap.
Some might be genuine bargains. But others turn out to be value traps, with a seemingly low valuation in fact reflecting risks that turn out to hurt business performance down the road.
Here is a trio of cheap shares I already own or would happily buy if I had spare cash to invest. All the shares have risks, but in the case of these three I am comfortable that those risks are reflected in the price.
Legal & General
The financial services giant Legal & General (LSE: LGEN) is focused on the sleepy world of pensions -– which is one reason I like it.
Managing pensions can involve substantial revenues and long-term customer relationships, setting the stage for ongoing financial success. Last year alone, Legal & General made post-tax profits of £2.3bn on revenues of £13.7bn.
That puts it on a price-to-earnings (P/E) ratio of under 7 making it a true cheap share in my view. On top of that, the FTSE 100 firm has a dividend yield of 8.9%.
Nervous markets or a tight economy could lead investors to withdraw funds, pushing down revenues and profits.
But as a long-term investor, I think those risks are acceptable for me when balanced against the valuation for the company. It benefits from a famous brand and large book of business that in some cases could stretch decades into the future.
Iron casting and machining group Castings (LSE: CGS) is another cheap share. It issued a six-monthly trading statement today (10 October) that said the company continues to trade in line with expectations.
A key risk is any substantial drop in demand for heavy trucks, which generate around three-quarters of Castings’ business. But I expect such demand to remain fairly solid in coming years. Companies need to replace aging fleets and logistics businesses remain busy.
With a P/E ratio of 10, I see it as a stock I could happily tuck away in my ISA. Its 9.5% dividend yield appeals strongly to me, although if profits fall in future the dividend may not remain at that level.
British American Tobacco
Cigarette usage is in long-term decline and is likely to stay so. Clearly that is a risk to revenues and profits at British American Tobacco (LSE: BATS).
But the decline has been happening for decades already in some markets and the firm still sold over 600bn cigarettes last year. Its premium brands allow it to charge high prices for what is a cheap product to make.
The business throws off large cash flows, supporting a 9% dividend yield. Meanwhile, as well as its legacy business, the company is forging a path to possible future profits from non-cigarette products such as its Vuse line of vapes.
Trading on a price-to-earnings ratio of 7, I think the price reflects the risks.