12 ‘out of form’ cheap shares: will they bounce back?

Investors, then, could do well by taking a look at a form of value investing, wh

In our seemingly never-ending world of low yields and overvalued stock markets, trying to find profitable investments is no easy task. Investors, then, could do well by taking a look at a form of value investing, which goes by the name of or ‘bottom fishing’ or ‘bottom feeding.  

As unappealing as its name sounds, bottom fishing suggests investing in ‘cheap’ shares, endorsing the value investing approach.

The idea behind value investing is that a catalyst will occur to revive an underpriced company's financial fortunes, in the form of a restructuring, refinancing or management change that increases its earnings and dividends.  

The trouble and danger with bottom fishing is that a company’s share price could decline much further before staging recovery, therefore investors risk catching a falling knife.

In the early years of the financial crisis, there was renewed interest in bottom fishing. And it was a good idea at the time, given that stock markets around the world had taken a battering. Smart investors swooped in and bought up the companies well below their real value, making a tidy profit in the process.

However, right now we’re in a bull market and by most measures stocks look pricey, particularly in the US. To go bottom fishing today takes a bit more effort.

According to Simon McGarry, a senior equity analyst at Canaccord Genuity Wealth Management, bottom fishing is an investment practice that can reap significant results in the current climate where ‘overvaluations are common’ and ’yields are stretched’.  

Therefore, McGarry has compiled a number of companies he thinks are undervalued.‘We've done some research looking at some equities we feel have been sold off indiscriminately, but where analysts who cover the stocks are being more positive,’ he noted.

12-month forward estimate
Stocks Industry Share
price
as a % of
12-month high
Price
Earnings
Ratio
EPS
growth
Dividend
yield
Imagination Tech Semiconductors and Semiconductor
Equipment
47% 27.6 145.4% 0.0%
IP Group Plc Capital Markets 64% 27.0 89.3% 0.0%
Greencore Food Products 68% 11.3 9.5% 3.2%
Hotel Chocolat Food Products 70% 32.4 11.2% 0.7%
Ricardo Professional Services 73% 12.7 7.7% 2.7%
FirstGroup Road and Rail 74% 8.3 10.7% 3.5%
Serco Commercial Services and Supplies 75% 36.1 8.9% 0.3%
Daily Mail & General Media 77% 11.5 3.9% 3.8%
Virgin Money (UK) Banks 77% 7.0 9.1% 2.3%
Indus Gas Oil Gas and Consumable Fuels 77% 19.2 25.5% 0.0%
Spire Healthcare Healthcare Providers and Services 78% 17.0 3.1% 1.3%
Spirent Comms Communications Equipment 78% 18.4 2.2% 3.2%

McGarry said that there are three key tests that must be applied to a stock before it should be considered in a bottom fishing strategy, in order to filter out cheap stocks that cheap for all the wrong reasons. ‘It is based on the premise that the low valuation is temporary and will bounce back at some point in the future, making the investor a profit,’ he adds.

First of all, the stocks must be trading at least 20 per cent below their 12-month high. So in the case of Imagination Tech, its share price is currently 47 per cent below where it was during its 12-month high. This suggest that the stock may be trading below its value – having been sold off in panics over a one-off profit report, or sold indiscriminately during larger events such as reaction to the UK’s vote to leave the European Union.

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Bottom fishing is risky: how do you know if the company you’re betting on will bounce back? Therefore, two other filters are applied. The earnings per share must be forecast to grow over the next 12-motnths and analysts must have been revising upwards their estimates for current-year projected earnings.

So, for example, FirstGroup is estimated to see its earnings per share rise by a respectable 10 per cent over the next year.

But don’t be seduced by sky-high earning per share growth estimates. Take Imagination Tech (see table above). Its earnings per share (EPS) is projected to boom by a 145.4 per cent. While that sounds impressive, investors need to look under the bonnet, as it doesn’t necessarily mean the business will have fantastically high profits in the future. The growth rate, expressed in percentage terms is high, but it could be because of profits having previously been so low, or non-existent, to begin with. A small jump in profits can lead to what appears to be a huge EPS growth rate.

McGarry pointed out that anyone looking into these bottom-fishing stocks should take a closer look at each company first. When he carried out the research, he says, he took a ‘very mechanical approach.’ While they qualified for his bottom fishing criteria, they may not be good bets.

Bottom fishing, McGarry emphasised, comes with risk: ‘the price is depressed for a reason and might well stay languishing at the bottom and not make a recovery at all.’ 

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