Buying unloved stocks in out-of-favour market sectors can be a profitable strategy. However, the market isn’t always wrong and such stocks can turn out to be value traps.
Today, I’ll explain why I’m giving a wide berth to two well-known names in the FTSE 250. On the face of it, they look to be among the cheapest stocks around, but I’m not convinced it’s wise to take them at face value.
A low price-to-earnings (P/E) ratio and a high dividend yield are two classic indicators of a potential bargain. Debenhams (LSE: DEB) catches the eye on both counts.
Its shares were trading at 75p this time last year but fell heavily following the Brexit vote. While some similarly hard-hit stocks have since regained ground, Debenhams’ shares remain depressed at 50.5p. This puts the company on a trailing price-to-earnings (P/E) ratio of just 6.5 and dividend yield of 6.8%.
However looking forward, Debenhams is facing increased import costs on sterling’s weakness and likely consumer belt-tightening in the face of rising inflation. The consensus of City analysts is for a 15% drop in earnings in the current year and a further 9% decline next year.
Furthermore, forecasts are trending down and I believe the consensus is likely to move towards the bearish end of the spectrum. This forecasts falls of 20% and 17%, bringing the P/E up to 9.7. In addition, Debenhams has a relatively high level of debt and the debt-adjusted P/E works out at 13.1.
Dividend forecasts are also trending down, with the City consensus calling for small cuts this year and next year. And, of course, bearish analysts are anticipating more severe cuts.
Finally, I mentioned the relatively high level of debt on Debenhams’ balance sheet. This contributes to the company having negative net tangible assets of £204m, compared with its market cap of £620m. Furthermore, the company has significant off-balance-sheet liabilities.
For all the above reasons, I’m inclined to view Debenhams as a stock to avoid.
Cycling into the wind
Halfords (LSE: HFD) shares have made something of a recovery since the post-referendum sell-off but it faces the same macro-headwinds as Debenhams. Again, I can see City consensus earnings forecasts moving towards the bearish end of the spectrum.
This would see a fall of 15% for the current year, followed by 5% next year. This is not as severe as for Debenhams, but the P/E is higher at 15.9. This doesn’t strike me as good value, even though most analysts are forecasting a dividend yield of 4.7% to be maintained.
Halfords has less debt than Debenhams (and much lower off-balance-sheet liabilities) and while it also has positive net tangible assets of £13m, this isn’t saying much compared with a market cap of £735m.
The company reckons parts of its business are resilient to macro-economic challenges. Nevertheless, I note that its shares fell by around 50% peak-to-trough in the last bear market. So, all in all, this is another stock I’m avoiding.
Risks and opportunities
I believe there are other sectors of the market - and, indeed, some companies within the retail sector - with better prospects than Debenhams and Halfords, whatever Brexit brings. With this in mind, the Motley Fool's experts have compiled a FREE guide called Brexit: Your 5-Step Investor's Survival Guide.
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G A Chester has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.