Not all cheap shares are worth buying. But if you choose the right ones, you can make a lot of money in the stock market. Today I’m looking at two FTSE 100 shares that both appear to be cheap at the moment.
Both stocks have high dividend yields and trade on low price/earnings ratios. These are classic signs of value, but I’m pretty sure that legendary value investor Warren Buffett would only consider buying one of these shares. Here’s why.
Pandemic boost lifts sales
The pandemic has driven a sharp increase in sales at supermarket group J Sainsbury (LSE: SBRY) this year. Retail sales excluding fuel rose by 8.5% during the 16 weeks to 27 June.
You might expect this to provide a boost for profits, but according to the firm that’s unlikely. Costs also rose sharply as Sainsbury’s recruited thousands of extra staff and faced other Covid-related costs.
In its latest trading update, Sainsbury’s said that Covid costs are expected to total around £500m this year. These will be “broadly offset” by around £500m of tax savings as a result of the government’s business rates holiday.
To me, it looks like the end result will be similar to if Covid-19 hadn’t happened. And that’s a problem. Sainsbury’s had issues before the pandemic and I don’t think they’ve gone away.
Why I’d avoid this FTSE 100 share
Sainsbury’s annual pre-tax profit has fallen from £898m in 2014 to just £255m last year. The dividend was cut in 2015, 2016 and 2017.
This group is simply less profitable than its main rivals. For example, last year Sainsbury’s generated an operating profit margin of 2.3%. The equivalent figure for Tesco was 3.9%. Morrisons managed 3.1%.
Sainsbury’s has sales of £28bn per year. Matching Morrison’s profit margins would have increased Sainsbury’s operating profit by about 35% last year. That’s a massive difference.
I’m pretty sure that Warren Buffett would see Sainsbury’s in the same way I do — a weak player in a very competitive business. Despite a tempting price tag of just 10 times forecast earnings and a possible 5.5% dividend yield, I’d stay away.
A cash machine?
One stock I think Mr Buffett might buy today is pension and asset management specialist Legal & General Group (LSE: LGEN). This FTSE 100 share has fallen by 36% so far this year, lagging behind the wider market’s 20% drop.
That’s disappointing for shareholders, but I think this sell-off may have gone too far. Although low interest rates and an uncertain economic outlook will create some challenges for Legal & General, this remains a very profitable business.
Profits dipped during the first half of the year due to the market crash, but Legal & General’s cash generation remained strong. The group’s operations generated £730m of surplus cash during the period, compared to £851m at the same point last year.
I’m pretty sure Warren Buffett would admire Legal & General’s strong cash generation and its historical return on equity of around 20%. Investing in businesses with these kinds of qualities has helped him become one of the world’s richest people.
Legal & General currently trades on seven times forecast earnings, with a dividend yield of 9%. I think that’s too cheap and view this FTSE 100 share as a buy.
