Buying recovery shares such as Footasylum (LSE: FOOT) and BT (LSE: BT.A) can be a risky move. The two companies have recorded disappointing share price performances of late. The former dropped by 50% on Monday following the release of a profit warning, while the latter has seen its valuation decline by over 50% in the last three years.
Looking ahead, further weakness may be ahead in the near term, with investor sentiment seemingly downbeat. But in the long run, could either share deliver improved performance which helps them to outperform the FTSE 100?
Footasylum’s trading update released on Monday showed that it is experiencing challenging trading conditions. Weak consumer sentiment has impacted negatively on its trading performance since the beginning of the current financial year. It has been especially weak over the summer, and this means that its adjusted EBITDA (earnings before interest, tax, depreciation and amortisation) for the full year is set to be less than half of the 2018 level of £12.5m.
The company is seeking to boost its financial performance through policies such as upsizing certain stores. While this could have a positive impact on the company’s future, there appears to be little sign of a recovery in consumer sentiment in the near term. As such, it would not be a major surprise for trading conditions to remain at difficult levels, which could translate into further share price falls.
Although the Footasylum share price may now have a lower valuation than it has had in recent months, the reality is that the company is experiencing a highly-challenging period. Therefore, it may be prudent to await evidence of the start of a turnaround before buying the stock.
With the BT share price having fallen from around almost 500p to 220p within the last three years, it is clear that investor sentiment has been weak for a sustained period of time. A number of telecoms companies in the FTSE 100 and FTSE 250 have experienced difficult periods in the same time period, with competition in the quad-play sector ramping-up as operators seek to diversify their product offerings. This could cause competition to rise, and may mean that margins are squeezed at a time when consumer confidence is weak.
Looking ahead, BT is expected to report a fall in earnings in each of the next two financial years. The stock market, though, seems to have factored this into the company’s valuation. The stock has a price-to-earnings (P/E) ratio of around 8.6, which suggests that there is a wide margin of safety on offer. This could cause increased demand for the company’s shares at a time when a number of FTSE 100 stocks may be starting to look overvalued.
Clearly, there is a long way to go with the company’s turnaround. A new management team will need time to put in place their own ideas and then execute their plan. However, with a low valuation and a diverse business model, the long-term prospects for the stock could be surprisingly strong.
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Peter Stephens has no position in any of the 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.