The idea of me buying a ‘cheap’ UK stock now is that over time, it should return to a fair value. In effect, if I can purchase something for less that it’s actually worth, I should be able to make a profit when others realise the correct value. The beauty (and difficulty) of the stock market is that there isn’t an exact science of identifying a cheap share.
However, here’s how I identify such stocks and a few that I believe are undervalued now.
Tools to sift through the market
One barometer I use to try and filter for a cheap stock is the price-to-earnings ratio. This measures the current share price relative to the latest earnings per share. The lower the ratio, the more likely it is that the share isn’t fairly priced. A rough guide of a fair value is a P/E ratio of 10.
There are currently 24 stocks in the FTSE 100 with a ratio below this mark. This is a large number, but I need to appreciate that this year has been a tough one for stocks globally. With investor sentiment not great, it does make sense that share prices of some companies have fallen drastically.
Another tool I use is the percentage price movement over the past year. I’m trying to identify companies that have lost at least X% in value over this period. Obviously, some stocks might have crashed for valid reasons that I need to discount. But I’m going to find cheaper stocks by looking at share price losses rather than identifying those that have rallied hard.
Stocks I like now
Barclays (LSE:BARC) is a major international bank, with divisions spanning retail, corporate and investment banking. The share price has fallen by 15% this year, with a current P/E ratio of 4.12.
The business has endured a tough year, with a trading error causing a loss in the hundreds of millions of pounds. However, Q3 results showed a 17% rise in income versus the same quarter last year. Higher interest rates are helping the bank, something that I feel could continue into next year.
M&G (LSE:MNG) is an investment manager. It currently has a low P/E ratio of 4.06, with the share price down by 6.6% over the past year.
A key element for the success of the company is attracting new money, from which it can then generate fees. In its half-year results, it said that “in only 12 months, we have reversed our position from being £2bn net client outflows, to achieving £1.2bn in net client inflows excluding Heritage”. I feel that if the business can continue to attract cash, profitability should take care of itself in years to come.
A risk for both financial stocks is what could happen with an aggressive recession next year. This could hurt Barclays via loan and mortgage defaults. For M&G, investors might pull out their money in fear and hold it in cash.
But I still feel both are strong options for me. When I have more free cash in January I’ll be considering adding these two stocks to my portfolio.
