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Cheap UK shares: 1 stock I’d buy and 1 stock I’d avoid

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World stock markets have rallied strongly over the last couple of weeks. The UK’s FTSE All-Share index, for example, has climbed 13% since 30 October. Yet there are still many cheap UK shares for investors to consider.

The two stocks I’m looking at today both trade on single-digit forward earnings multiples. I think one of them could be a genuine bargain, but I’m very wary about the other. Read on, and see if you agree with me!

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Cheap UK shares #1

The share price of roadside assistance firm AA (LSE: AA) has outperformed the wider market so far this month. At 28.8p, it’s up over 25%.

Nevertheless, it remains at a huge discount to its historical levels. On a one-year view, it’s 40% below. And, over three and five years, down 82% and 89%.

Yet the company said in its latest interim results it had delivered “a remarkably strong performance in the first half.” It also reiterated its full-year guidance for an outturn “only slightly below that of the prior year.”

The shares are trading at an extraordinarily low 2.2 times forecast earnings. Surely this has to be one of the biggest bargains in the market?

Why I’d avoid AA

AA’s problem is its huge debt pile. And this, in a nutshell, is why I’d avoid the stock. At the half-year end, net debt stood at £2.6bn — an eye-watering 7.3 times trailing 12-months EBITDA. Meanwhile, shareholders’ equity was negative to the tune of £1.6bn.

Too right the company is “continuing to review a range of potential refinancing options, including the possibility of raising new equity.” This in addition to continuing discussions with a private equity consortium “regarding a possible all-cash offer.”

Given the dire state of the balance sheet, I can’t see the existing equity being valued anything much above its current price in the market (market-cap £180m) in a refinancing or cash offer. And there are scenarios in which it could wind up being valued a lot lower.

Cheap UK shares #2

Support services firm Capita (LSE: CPI) has also outperformed the wider market in recent weeks. Its shares have surged almost 60%, helped by a “resilient” trading update last Tuesday.

Nevertheless, like AA, the company’s share price is still heavily down from a year ago (74%), as well as over three years (87%) and five years (95%). At a current price of 39.17p, it’s market-cap is £654m, and it’s valued at 6.1 times forecast earnings.

Why I’d buy Capita

Capita’s balance sheet isn’t exactly strong. But it’s a lot less scary than AA’s. Net debt is much lower at £1.1bn, as is gearing at 2.7 times EBITDA. And while shareholders’ equity is negative, at £139m, this too is considerably less grim than AA’s.

I’ve been impressed by Capita’s progress since a boardroom clearout a few years ago. The Covid-19 pandemic has delayed but not derailed the progress of the turnaround, in my view.

On this basis, along with the cheap earnings multiple and better-than-beastly balance sheet, I reckon the shares are very buyable at their current level. I think the stock has strong credentials as a higher risk/higher reward pick for a diversified portfolio.

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G A Chester 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.

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