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Tempted by the IAG share price and 7% yield? Here’s what you need to know

Taking a contrarian stance when investing can sometimes deliver big profits. But not all cheap stocks are bargains. Sometimes the market has spotted problems on the horizon and is pricing the stock accordingly. Here, I’m going to look at two FTSE 100 stocks which look cheap and boast 7% dividend yields. Is now the time to buy?

A high-flying bargain?

British Airways owner International Consolidated Airlines Group (LSE: IAG) is facing rising fuel costs and tough competition on short haul routes. But the group’s long-haul operations are performing better.

Although the IAG share price has fallen by more than 35% over the last year, the group’s profits don’t yet reflect such a downbeat outlook. On Friday the company reported an operating profit of €1,095m for the first half of the year, just 2% lower than for the same period last year.

What could go wrong?

The problem with investing in airlines is that they have very high fixed costs. This can leave them facing big losses during economic downturns, when demand tends to fall. To run several large airlines like IAG, you need hundreds of planes, thousands of staff, and lots of expensive landing slots. If demand falls, these costs still have to be met, even though ticket revenues will slump.

To get an idea of what could happen, I’ve taken IAG’s results from the last 12 months and modelled a 10% drop in revenue and a 5% fall in costs. The result was operating profit for the 12-month period fell by nearly 50%, from €3,038m to just €1,622m.

This experiment suggests to me the group’s 10% operating margin could be quite fragile if market conditions worsen. I think this is why IAG shares are currently trading on just four times 2019 forecast earnings. Although I’m tempted by its forecast dividend yield of 7%, I wouldn’t buy these shares at the moment.

Should I sell this FTSE faller?

One unloved stock I already own is Royal Bank of Scotland Group (LSE: RBS). The share price was down by 6% at the time of writing after the bank warned it was “very unlikely” to hit its financial targets for 2020. The good news is the 2019 performance should be in line with expectations. Shareholders will also receive a 12p per share special dividend, taking the expected stock’s yield to more than 7%.

The bad news is that competition is tough in the mortgage market and businesses are holding back on new borrowing due to Brexit uncertainty. RBS says the uncertain outlook is likely to put pressure on profit margins next year.

Buy, sell, or hold?

As a shareholder, I’m not too worried. Today’s figures show that bad debt levels remain relatively low and confirm the bank’s strong balance sheet. I can also see welcome improvements in areas the bank can control. For example, costs accounted for 57% of income during the first half of 2019, compared to 70% for the same period last year.

RBS shares now trade on about eight times forecast earnings and at a 30% discount to their book value of 290p. There’s also a 7% dividend yield on offer for 2019, with a similar payment expected next year. In my view, this valuation is still attractive. If the share price continues to weaken, I may buy more over the coming months.

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Roland Head owns shares of Royal Bank of Scotland Group. 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.