A better way to look for very cheap shares

There are lots of different ways to search for winning shares. One thing you can be sure of though is that no strategy is guaranteed to deliver you stunning results year in, year out. That's because different styles of investing tend come in and out of fashion which can be very frustrating if you are not making money.

To be a good investor, you need to be patient and stay disciplined. Chopping and changing in response to the ups and downs of the markets rarely pays off. If you've done your homework and your analysis of a company is good then sometimes you just have to accept that it can take a while for other people to recognise what you've discovered.

If you look at strategies that have worked well in the past a few common themes keep cropping up. One popular approach is to look for very cheap shares that might have been neglected by the market. This is the rationale behind what is known as value investing. Famous investors such as Benjamin Graham, John Neff and Warren Buffett made their fortunes this way

So how do you go about finding really cheap shares?

With ShareScope there are lots of different tools that you can use to weigh up the value of a share. One of the most popular ways of spotting a cheap share is to look at its price earnings or PE ratio

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Buying shares with low PE ratios

To calculate a PE ratio you simply divide a company's current share price by its latest or predicted earnings per share (EPS). EPS is your slice of the company's after tax profits every year.

P/e = Share price/EPS

What the PE is effectively telling you is how many years of the company's current after tax profits are reflected in its current share price. So a company with a share price of 100p and EPS of 50p trades on two times profits or a PE ratio of 2. Another company with the same 100p share price and EPS of 2p would trade on 50 times profits. The higher the PE ratio, the more expensive the shares are seen to be.

Value investors argue that high PE ratios are a sign that the market is pricing in a very rosy future for a company and expects profits to grow fast. More often than not these expectations are not met and the share price comes crashing down often leaving the shareholder nursing some very painful losses.

When you buy shares with low PE ratios they are often unloved. This is usually because the companies concerned have fallen on hard times and their profits are or expected to be depressed. Expectations of the future can be very downbeat.

But if these hard times are only temporary and profits can recover then the buyer of these shares can make a lot of money providing they have the patience to wait.

It's important to understand that a share price can stay too high or too low for a very long time. This is because people tend to extrapolate the most recent trend in the company's fortunes far out into the future. They don't tend to be very good at predicting when those fortunes will change. That's why share prices can move sharply up and down when they do.

Low PE investing has a good track record

Buying cheap shares has worked well over the long haul. The best returns have come to those who have been able to stick with the strategy through good times and bad.

James P O'Shaughnessy in his book "What works on Wall Street" has a very interesting study on the long-term track record of low PE investing. Buying an equally weighted portfolio (the same amount of money invested in each share) of the top decile (top 10%) of low PE shares in the US market at the start of 1964, rebalancing it every year through to the end of 2009 saw annual gains of 16.25% per year.

This strategy trounced the US market which had average annual gains of 11.2%. Buying the top decile high PE shares produced average annual gains of 5.53%. You'd have actually been slightly better off owning a portfolio of short-term US government bonds (known as T-Bills) instead of buying the most expensive shares.

Low PE shares beat the market 92% of the time for rolling five year periods and 99% of the time for rolling ten year periods. The only time that high PE shares seemed to do well was at the end of bull markets such as the internet and technology mania at the end of the 1990's.

Screening for shares with low PE ratios

If you want to look for shares with low PE ratios you can easily do this in ShareScope. It's up to you but you have the choice of screening for shares with PEs based on their last reported or historic EPS or ones based on the forecasts of City analysts.

I've run a screen in ShareScope looking for shares in the FTSE All Share Index with one year forecast PE ratios of between 1 and 9. I've ignored financial companies as PEs are arguably not the best measure of value for them (a subject I will return to in the next few weeks). I've also missed out low PE companies such as Punch Taverns (LSE:PUB) and Enterprise Inns (LSE:ETI) as we are still waiting for some fresh data here.

Here is a list of 21 companies that fit my screening criteria. Only 30 shares in the FTSE All Share met the criteria as of the morning of 4th December 2014.

A selection of Low PE shares from ShareScope:

NameSectorForecast PE
Ferrexpo PLCIndustrial Metals & Mining3.3
EnQuest PLCOil & Gas Producers4.1
Trinity Mirror PLCMedia4.5
Premier Foods PLCFood Producers4.6
Afren PLCOil & Gas Producers5.3
Premier Oil PLCOil & Gas Producers6.2
Johnston Press PLCMedia6.5
Hogg Robinson Group PLCSupport Services6.9
Menzies (John) PLCSupport Services7
Exillon Energy PLCOil & Gas Producers7.2
Mecom Group PLCMedia7.3
Lamprell PLCOil Equipment, Services & Distribution7.4
Petrofac LtdOil Equipment, Services & Distribution7.4
Gulf Marine Services PLCOil Equipment, Services & Distribution7.7
TT electronics PLCElectronic & Electrical Equipment7.9
St Modwen Properties PLCReal Estate Investment & Services8
Anglo-Eastern Plantations PLCFood Producers8.1
Redrow PLCHousehold Goods & Home Construction8.1
Findel PLCGeneral Retailers8.6
SOCO International PLCOil & Gas Producers8.6
Sainsbury (J) PLCFood & Drug Retailers8.9

As of 4/12/2014

As you can see, the recent fall in the oil price has pushed a lot of oil and oil-related companies into the low PE camp. There are also some media, food and retailing companies that seem to have fallen out of favour too.

So would it make sense to just go and blindly buy these shares and hope for the best?

Unsurprisingly, the answer is no. For starters buying 21 shares will rack up a hefty bill in broker commissions and stamp duty costs. But if there's one thing to realise above all else it's that investing is not like painting by numbers. It's important to understand why shares have low PE ratios so that you can try and avoid putting your money into a business that looks cheap for good reasons - known as a value trap.

Things to bear in mind

For example, a company may really be in trouble. Do your own research and look at how it has been performing recently. The annual report and the company's investor website are good places to start your investigation. It's possible that a business may genuinely be heading for the rocks if it has lost its competitive edge or has dodgy finances.

Also use ShareScope to look at a company's profit history. Are profits unsustainably high or could they be about to recover? Remember that there's lot of clever people out there who spend all day studying companies for a living. They may have correctly anticipated that a company's profits are about to fall off a cliff in the next year or so.

This makes the PE look low because analysts haven't reflected this in the next year's profit forecast and the EPS figure they have estimated is likely to fall afterwards. That's why companies whose profits have already tanked with low PEs might prove to be a more fertile hunting ground.

EBIT/EV - a smarter way to find cheap shares

The PE ratio can be a very useful way of hunting for cheap shares but it does have some drawbacks. For me, the most serious one is that it flatters companies with lots of debt.

Basically debt makes shares look cheaper on a PE and can fool people into thinking shares are cheap when they are not. The good news is that there is a tool available in ShareScope that can help you avoid this. It's called EBIT/EV which is a variant of earnings yield.

In ShareScope, add a Results column, go to Ratios tab of the Results dialog and click on Earnings yield. You'll get the additional options of EBIT/EV and EBITDA/EV.

Wesley Gray, an American who is a bit of an expert on value investing has done a lot of research into the best valuation measures to pick winning shares. As far as he is concerned, the best measure is to compare a company's earnings before interest and tax (EBIT) - or trading profits - with the enterprise value (EV) paid for a company (the market value of its equity plus its debt minus its cash). This gives an earnings yield for the whole business expressed as an interest rate. The higher the interest rate, the cheaper the share.

The reason that EBIT/EV works so well is that gives you a lot of information about what you are paying for the assets of a business or enterprise value (which are financed by its equity and its borrowings) and the profits that are actually produced from them - EBIT. If you just concentrate on the equity of a business you could make mistakes and buy the wrong business or pay the wrong price

Let me show you what debt does to PE ratios and why EBIT/EV is something that you should start looking at.

Say there are two identical petrol stations for sale where you live. Both have an asking price of £1 million and both have annual trading profits of £100,000. The first petrol station, known as Petrol Pump is financed with a £800,000 bank loan at an interest rate of 5% leaving it with remaining equity left over of £200,000. Rival business Oil Tanker has no debt at all, so has an equity value of £1 million.

 Petrol PumpOil Tanker
Asking price (EV) = A£1,000,000£1,000,000
Borrowings£800,000£0
Equity = B£200,000£1,000,000
EBIT = C£100,000£100,000
Interest on borrowings-£40,000£0
Profit before tax£60,000£100,000
Tax at 20%-£12,000-£20,000
Profit after tax = D£48,000£80,000
P/e ratio = B/D4.2x12.5x
EBIT/EV = C/A10%10%

By using PE ratios you could be mistaken for thinking that Petrol Pump is considerably cheaper than Oil Tanker when in fact they actually have the same value when EBIT/EV is used.

If you want to think in terms of PEs then logically Petrol Pump should look cheaper on this basis because all the debt it has makes it a much more risky investment for an equity investor.

Revisiting the low PE shares again

NameForecast
PE
Mid/
Close
Capital
(£m)
EV
(m)
DebtDebt/
MCap
2014
low
EBIT/
EV
Ferrexpo PLC3.30.6940478538194%0.6828.3
EnQuest PLC4.10.4939362723459%0.4335.3
Trinity Mirror PLC4.51.443724598723%1.3720.1
Premier Foods PLC4.60.373031134831274%0.277.2
Afren PLC5.30.47525103450997%0.4632.8
Premier Oil PLC6.21.991018189287386%1.8716.9
Johnston Press PLC6.51.6169464294174%1.5312.4
Hogg Robinson Group PLC6.90.431392036446%0.3922.1
Menzies (John) PLC73.4721332010750%3.1816.3
Exillon Energy PLC7.21.4723724131%1.089.5
Mecom Group PLC7.31.341631953220%0.876.8
Lamprell PLC7.41.28436324-112-26%1.1311.7
Petrofac Ltd7.48.072744319244816%8.0714.8
Gulf Marine Services PLC7.71.0637156919853%1.0611.2
TT electronics PLC7.91.07171144-26-15%1.0321
St Modwen Properties PLC83.9862120634540%3.348.3
Anglo-Eastern Plantations PLC8.16.2246207-39-16%6.0638.9
Redrow PLC8.12.811040121217317%2.2911.6
Findel PLC8.62.1182389207114%1.978.4
SOCO International PLC8.62.72902824-79-9%2.7231.4
Sainsbury (J) PLC8.92.4146035795119226%2.2517.1

Now take a look at the list of low PE shares again.

You can see that quite a few of them have lots of debt (expressed as a percentage of their market capitalisation) which will have lowered their PE ratios. I've used the EBIT/EV data from ShareScope to look at how the value of the whole business - not just the equity part - stacks up.

If a company has a low PE and a high EBIT/EV you may have a share that is very cheap and worthy of further investigation.

Some more questions to ask

  1. At the moment ShareScope calculates EBIT/EV on a historic rather than forecast basis (we will be adding forecast data in the future). Historic profits may be too high and unsustainable. Check that the company's profits are sustainable and that it hasn't warned that they will fall or reported lower ones. (You can use the news section of ShareScope to do this).
  2. Does the company have too much debt? Use ShareScope to check the company's interest cover so that it can comfortably pay the interest on its borrowings.
  3. How depressed are the shares? Use ShareScope to compare the current share price with the low for the year. A share may already have bounced sharply off its lows meaning you may have missed a chance to make some early gains.

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This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.