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Two dirt cheap 5%+ yielders I’d avoid at all costs

As domestic equity indices roar higher and higher of late, the amount of stocks popping up on my value investing screens are becoming fewer and farther between. And on these lists, there are a handful that certainly appear to me to be value traps rather than hidden gems. One such stock is diversified construction and homebuilder Galliford Try (LSE: GFRD).

With the company’s stock trading at just 10.5 times forward earnings and offering an 8% dividend yield that is covered by earnings, it’s easy to see why many investors would be intrigued. But lurking beneath the surface there are internal issues that have me nervous.

The first thing scaring me off is the profit warning announced in May that forecast a £98m one-off hit due to two large infrastructure projects running over time and budget. This caused analysts to revise downward full-year pre-tax profit guidance from a consensus estimate of around £150m to £50m.

Now, management is confident this issue won’t rear its ugly head again and has transitioned away from fixed-price infrastructure projects to ensure this. However, the project that accounts for 80% of the writedown isn’t scheduled to complete until mid-2018, which leaves plenty of time for further problems to arise. So, until both of these projects are completely finished, I’d exercise caution.

Another cause for concern in my eyes is that the group’s highly profitable Linden Homes brand is overshadowed by low-margin construction and partnership and regeneration divisions. In the half-year to December operating margins in the homebuilding division had risen to 18.2% while those of the other two divisions fell to 3.4% and 0.4% respectively. If I were a shareholder, I’d be clamouring for a spin-off or sale of these two low-margin divisions that already caused the aforementioned profit warning.

On top of these internal issues, it’d take a very special opportunity for me to invest in highly cyclical construction firms at this point in the economic cycle. And Galliford Try, with lower margins and higher debt than competitors, not to mention the potential for more profit warnings, does not fit the bill for me.

Barking up the wrong tree

Another stock appearing on my value screens that I’d steer clear of is retailer Pets At Home (LSE: PETS). The company’s shares now trade at a sedate 12.2 times forward earnings while kicking off a 5.2% dividend yield.

The cause for trepidation in this case is slowing sales growth from the company’s merchandise offerings, which remain the largest part of the business. In the year to March, like-for-like (LFL) sales growth from merchandise was a tepid 0.8% and was boosted by the company’s lower prices to attract more customers.

This appears to me to be a losing game as Pets At Home cannot indefinitely compete on price with online retailers such as Amazon, or with discount retailers. They can all offer lower prices while maintaining higher margins thanks to their specialised business models.  Indeed, gross margins fell 35 basis points in 2017 to 54.2% due to discounting and a higher proportion of sales from its lower-margin veterinary care division. With margins marching lower, sales growth sputtering and broader industry trends a major worry over the long term, I can’t say I’m tempted by Pets At Home.

A bargain basement option that does tempt me is the Motley Fool's Top Small Cap of 2017, which trades at a rock-bottom 8 times earnings. On top of this low valuation the company is also an impressive growth stock with four straight years of double-digit earnings growth behind it.

To discover this under-the-radar growth value option for yourself, simply follow this link for your free, no obligation copy of the report.

Ian Pierce has no position in any shares mentioned. The Motley Fool UK owns shares of and has recommended Amazon. 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.