The Motley Fool

Dirt cheap and offering big dividends. So why am I shunning this small-cap?

On initial inspection, footwear retailer Shoe Zone (LSE: SHOE) looks a tempting investment. Trading on just 11 times forecast earnings before today and offering a cracking 5.5% yield, it’s unsurprising if the business catches the collective eye of those searching for value (and/or income) in a market that is looking increasingly frothy. Net cash position? Check. Growing returns on capital? Another tick.

So why am I bearish on the stock? A quick scan of today’s interim results should help to explain.

Profits tumble

In the six months to 1 April, sales at the Leicester-based, £94m cap dipped from £74.6m to just under £73m. More concerningly, pre-tax profits nosedived to just £300,000 compared to £1.9m over the same period in 2016. Much of this can be attributed to the fall in sterling following last June’s shock referendum result and an overhaul of its store estate. 

Nick Davis, CEO of Shoe Zone, did his best to put a positive slant on today’s numbers, stating that the impact of sterling’s fall would be “significantly reduced” going forward and that trading since the period end had been in line with management’s expectations. He also remarked that the company’s trial of its Big Box store concept had performed well and that the rollout would be accelerated over the rest of the year. A target of 10 such stores by the end of 2017 was set. A 24% rise in sales of Shoe Zone’s non-footwear range was also encouraging.

Based on early trading, however, the market isn’t convinced. At the time of writing, shares in Shoe Zone are down just over 5% to 178p. 

Aside from today’s poor numbers, I think there are other reasons to avoid the retailer. For one, operating margins will always be stubbornly low for this kind of business. Moreover, analysts are only forecasting a 2% rise in earning per share in the next financial year, making shares in Shoe Zone look far less like the bargain they first appear to be.

A better fit for your portfolio?

Shoe Zone’s competition must also be considered. The idea that shoppers would prefer to visit its stores when other budget retailers — such as Primark — have sites in better locations and far wider product ranges is hard to fathom. Indeed, I suspect that investors wishing to profit from those offering low-cost clothing and footwear are better off looking at the latter’s owner, Associated British Foods (LSE: ABF).

In addition to its diversified portfolio (featuring businesses in segments such as sugar, agriculture, grocery and ingredients), the £24bn cap’s presence in 50 countries means it also offers the kind of international footprint that Shoe Zone lacks. The company has a 17% earnings per share rise pencilled in for the current year with a further 9% rise expected in 2017/18. Boasting excellent free cashflow and a £190m net cash position as of April, this is one retailer that should remain resilient if retail spending to continues to drop as a result of rising inflation and slowing wage growth. If anything, I think Associated British Food offers far more protection for investors than most as consumers begin to tighten their purse strings.

Sure, the dividend yield is negligible (1.4%) and a price-to-earnings (P/E) ratio of 25 for 2017 will put some investors off completely. Nevertheless, when compared to Shoe Zone, I think Associated British Foods looks a decidedly less risky pick.

Like Associated British Foods?  You'll love these...

If you're on the hunt for large firms offering great dividends and a history of generating excellent returns whatever the economic climate, look no further than these five superstocks identified by those canny analysts at the Motley Fool. They believe these companies make perfect investments for retirement-focused investors.

Their report is completely FREE and without obligation. Just click here and it's yours.

Paul Summers 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.