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Cheap UK shares: 3 questions I’d ask to choose stocks with the highest returns

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All investors like great returns on their investments. And one of the most straightforward ways to achieve that is by buying cheap UK shares. Low priced shares allow us to buy a larger lot in one go, which can quickly double or treble the value of our capital.

I get the appeal, especially since there’s such a vast difference between the share prices of even just stocks in the FTSE 100 index. For instance, each share of Lloyds Bank costs around 35p, while each share of Flutter Entertainment costs almost £150.

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But not all cheap UK shares are made equal. Unlikely as it sounds, some may actually end up making us lose capital. So I’d ask these three questions before buying them:

#1. Is the share price rising?

Some shares are cheap simply because their fortunes have taken a turn for the worse, and investors have little confidence in them. Consider the FTSE 100 supermarket J Sainsbury, which has a share price of £2.25. Not as low as Lloyds Bank, but it would still be counted among cheap UK shares, at least in the FTSE 100 index. 

Even though 2020 hasn’t been a disaster for SBRY, whose share price has risen in the second half of the year, it’s still quite low compared to past years. These are tough times for retailers and SBRY is one of them, whose financials aren’t looking great either. From a long-term investment perspective, I feel unsure about SBRY too. I don’t know how far and how fast this share is going to go. In fact, I think there’s risk of it falling further. 

#2. If yes, is it rising faster than the pricey stocks?

Not all cheap UK shares are so for all the wrong reasons, however. Sometimes, high growth stocks can come in the category too. A recent example is the FTSE 100 British Airways owner, International Consolidated Airlines, whose share price plunged because of Covid-19. On average, it was on the rise in the five years before that.

And even now, it has made some smart gains in November’s stock market rally that followed the Covid-19 vaccine development. Its share price is up more than 50% since then. While many other stocks have made gains since then too, as would be expected in a rally, this increase is far superior to what many others have seen. It’s enough for me to sit up and take notice. 

#3. Does the cheap UK share pay a dividend?

Not all is lost, however, if a cheap UK share isn’t either growing faster than others or not growing at all. If there’s still a healthy dividend yield in the mix, investors can still make some gains. 

Consider the insurance provider, Legal & General. Its share price pre-stock market crash was largely flat on average, but it has a huge dividend yield of 6.9% right now. And after the crash, its price is actually rising again. I think it can be a good buy to generate a passive income. 

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Manika Premsingh has no position in any of the shares mentioned. The Motley Fool UK owns shares of Flutter Entertainment. The Motley Fool UK has recommended Lloyds Banking Group. 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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