Value investing focuses on identifying companies whose shares look undervalued by the market. This approach, long favoured by legendary investors such as Warren Buffett, is underpinned by a belief that share prices eventually catch up with company fundamentals.
But focusing solely on headline value metrics can be dangerous.
Take AA (LSE: AA) for instance. This industry stalwart is currently valued at just six times last year’s earnings and under three times 2018’s earnings. In fact, its market capitalisation is less than one-third of its annual sales revenues.
The breakdown recovery provider reported a net profit of £34m in the first half of the year, up 47% from the year before. If the company produces a similar result in the second half – as expected – the shares would trade at a price-to-earnings (P/E) ratio of just four. This would be almost unheard of for such a well-known company, operating in an industry with such strong barriers to entry.
But this only tells half the story. The group is actually weighed down by a gigantic debt load. At the end of the first half of the year, AA’s net debt stood at around £2.6bn, a colossal seven times EBITDA (earnings before interest, tax, depreciation, and amortisation).
At present, operating profits and cash flow more than cover interest expenses. However, any slip up would put pressure on the group’s ability to service its debts. Its net interest costs totalled £166m last year.
The best scenario is that the group generates enough cash flow to steadily reduce its debt load, though this could take some time. A big worry of mine is that AA may have to go cap in hand to investors for additional equity, effectively diluting the company’s shares.
For now, the only value in these shares comes from its 4% dividend, which effectively means the shares are little more than a bond proxy. I do think there is the potential for some gains, but I think the stock is best left avoided for now.
A growth story
One company that I’d sooner invest in is Goco (LSE: GOCO), formerly Go Compare. The group, renowned for its price comparison service, and its moustached tenor, is in the midst of a tech-led transformation.
Alongside its established price comparison business, the group has now launched a new business segment, AutoSave. AutoSave helps customers save money on their energy bills, and is focused on the huge number of UK households that rarely switch energy providers.
Management expected to grow live customers in this new division to more than 260,000 by the end of 2019, up 50% from July of last year. The group calculates the addressable market to be around 23m UK households. If it can capture just a slice of this market, then profits should move materially higher.
Short-term profits are set to be impacted by investments in the new business line. But with AutoSave profit margins predicted to be significantly higher than those of the price comparison business, the move could be earnings enhancing beginning as soon as next year.
With a P/E ratio of 13 times last year’s earnings, and a stable price comparison business that remains the backbone of the business, I think these shares are worth buying. In my mind, this represents much better value than debt-mired AA.
Thomas 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.