Sarcasm aside, today’s share price crash following the release of its latest trading statement, and news of another fundraise, are yet more evidence as to why I’d avoid the shares like the plague.

Making “good progress”

Perhaps I’m being harsh. After all, the company has said it’s continuing to make “good progress” on realising its potential and becoming “a true luxury company.“

While trading understandably “remains challenging” in wake of the pandemic — sales are expected to be lower in Q2 compared to Q1 — there are a few green shoots to mention.

First, over 90% of the firm’s dealer network is now open, although only 50% are operating at full capacity.

Having completed all trials and commenced production at its St Athan facility, Aston Martin also said it was also on schedule to release its new luxury SUV (the DBX) in July. The order book for this new vehicle was today described as “strong.“

In addition to this, the company has reduced the amount of cars in showrooms in an effort to “regain price positioning and exclusivity.” By the end of May, unsold dealer stock had fallen by 617 vehicles.

Commenting on today’s statement, new executive chairman Lawrence Stroll said that he was “enthusiastic and confident” about the firm’s multi-year plan to revitalise the company. I’m somewhat more sceptical. 

Show me the money!

Of course, the problem with Aston Martin has never been the cars. The problem has always been the finances. On this front, there was more bad news for existing holders today. 

Despite taking “decisive action” to get costs and investment under control (including the furloughing of employees), the company has once again been required to go cap-in-hand for money. This isn’t surprising — the company hinted as much last month. 

Having been approved for a £20m loan from the government via its Coronavirus Large Business Interruption Loan Scheme, Aston Martin will now seek to raise roughly £190m by selling shares worth just under 20% of the business. Another $68m will be accessed from a credit line at a very high 12% interest. 

If all this jargon sounds confusing, don’t worry. Just know that Aston Martin remains in a pretty precarious financial position. Net debt at the end of May stood at £883m. That’s only slightly less than the value of the company itself. It’s also a truly rubbish situation for those already invested, as the value of their stakes is diluted again.

Avoid Aston Martin

Aston Martin makes beautiful cars. Period. It’s performance on the market since listing, however, is akin to an old banger. It’s also a cautionary tale for all investors. It doesn’t matter how great the product is. Take the time to look beyond the glitz and glamour before pressing the ‘buy’ button. 

The company will release its interim numbers for the first six months of 2020 on 29 July, shortly before new CEO, Tobias Moers, takes the wheel. It’s possible his arrival could prove the point at which the shares gain a surer footing. I wouldn’t want to bet on it though.

Unless you enjoy risky stock market rides, I’d continue to steer clear of Aston Martin. 

The post Aston Martin shares crash another 10%! Here’s why appeared first on The Twelfth Magpie.

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Does today’s cost-cutting measure mean the shares are now a canny contrarian play? Here’s my take.

Were Royal Mail’s numbers that bad?

There certainly weren’t great. While revenue came in at £10.84bn over the 12 months to 29 March (up 3.8% from last year), adjusted operating profit was 13.6% lower (£325m). 

Broken down, it’s the UK Parcels, International and Letters division (UKPIL) that continues to be a drag. Revenue here grew 1.6% to £7.72bn but adjusted operating profit fell a worrying 41.2% to £117m.

The vast majority of the remaining revenue was achieved via the company’s Europe-focused subsidiary (GLS), where adjusted operating profit rose 17.5% to £208m.  

It doesn’t look like things will get better soon either. Over the first two months of the new financial year, year-on-year revenue is down £29m at UKPIL. Moreover, total costs are already up £80 due to overtime, staff absences and social distancing measures.

Clearly, the company needs to take action and that’s what it’s done.

Job cuts

Commenting on today’s numbers, interim Executive Chair Keith Williams reflected that the UK business had “not adapted quickly enough” to people sending a greater number of parcels and fewer letters. The pandemic “has accelerated those trends,” Mr Williams said, “presenting additional challenges”. 

As such, the company has announced that it’s looking to cut 2,000 management roles — roughly a fifth of its management total. It’s also reducing capital expenditure by around £300m over the next two years.

Bargain buy?

Of course, there comes a point when even the most hated stocks have the potential to make money for brave investors if they’re cheap enough. Based on the company’s own outlook, however, I’d continue to give Royal Mail a wide berth.

In spite of the plan announced today, the company stated that the coronavirus pandemic means its future is “challenging and volatile”. UKPIL is expected to be “materially loss-making in 2020” and profits at GLS “may potentially be reduced”.

Assuming coronavirus-related restrictions lift after June and UK GDP falls by ‘only’ 10%, year-on-year revenue is expected to fall by between £200m and £250m. Costs from the virus will reach £140m with a further £110m hit predicted from higher parcel volumes.

Should things turn out a lot worse than this (say, GDP declines by 15%), like-for-like revenue would likely fall by between £500m and £600m. Costs would be even higher.

Whichever scenario plays out, this is pretty tough reading for its owners, even if some of this is already reflected in the share price.

Don’t expect dividends

Aside from the above, would-be investors need to be aware that there will be no dividends paid in the new (current) financial year. Personally, the idea that these will return in FY22 strikes me as optimistic. 

It’s also worth mentioning that the company is the fifth most shorted stock as I type, according to shorttracker.co.uk. Put simply, this means a lot of market participants are betting that the shares will continue to fall in value.

All told, I think there are far better options right now than Royal Mail, particularly for income hunters. The road ahead will be long and hard. Don’t expect the shares to deliver any time soon. 

The post Royal Mail shares crash AGAIN, but are they now a bargain buy? appeared first on The Twelfth Magpie.

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Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.

With this in mind, is it possible to double your capital with a stock like battered energy giant and FTSE 100 member Centrica (LSE: CNA)? Here’s my take.

Losing its crown

As anyone with a casual interest in Centrica will know, the owner of British Gas isn’t devoid of problems. Arguably the biggest faced by the business right now is its dwindling customer base. Indeed, an increasing number of nimbler competitors and the ease at which people can now switch suppliers has led the market leader to haemorrhage around 2m members over the last four years.

Given the Labour party has made no secret of its desire to re-nationalise energy suppliers, if elected, another concern for Centrica in recent times has been the prospect of a Labour government. Whether you believe Jeremy Corbyn could ever make it into Number 10 or not, the mere possibility — combined with the current Government’s cap on energy prices — demonstrates how exposed the company is to political interference.

All this before we’ve touched on the fact that Centrica has been (and will continue to be) impacted by things it can’t control, namely commodity prices and the weather. Oh, and it’s also shortly to become rudderless with CEO Iain Conn stepping down next year.  

No wonder it’s cheap!

Having halved in value in just 12 months, Centrica’s stock is left trading at a little under 11 times forecast earnings. If we momentarily assume the share price doesn’t budge, this falls to under 8 times in FY20, based on analyst assumptions that earnings will bounce back to form. This suggests the stock could be a bargain, relative to both the wider market and peers. 

Unfortunately, it’s not that simple. For the £4.2bn-cap to double in value from here, there needs to be a catalyst for it to dramatically improve its popularity with consumers and recruit a strong CEO while keeping the dividend at a reasonable-but-still-attractive level. That’s quite a challenge.

On the first point, the best existing investors can hope for at the moment is that the outflow of customers is halted. We’ll see whether it’s managing to do this when it reports on Q3 trading next month. Good news will see the share price soar, but I’m not holding my breath.

Finding someone to take on the poisoned chalice of leading the company could also be difficult, particularly given the criticism, however justified, handed out to the departing Conn by the media and shareholders.

And then there’s the dividend. Despite being sliced, the total payout this year is expected to be 5.1p per share, which still equates to a yield of almost 7%. With cash returns covered only 1.4 times profits, I wouldn’t rule out another cut — and investor exodus — if the company misses earnings estimates.

In sum, doubling your money through Centrica is not beyond the realms of possibility, but it will surely require the mother of all recoveries. Why take the risk when you can make good money elsewhere in the market at far lower risk?

The post Can the Centrica share price double your money? appeared first on The Twelfth Magpie.

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Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.

Unfortunately, ‘value investing’ — or buying stocks for lower than their intrinsic value and waiting until their stock prices correct — is harder than Mr Buffett made it look with many ‘bargain’ stocks turning out to be absolute dogs for their holders. Here are just a few ways of spotting and avoiding them.  

1. Sky-high dividends

Chunky dividends attract investors like moths to a flame. However, as holders of stocks like Centrica and Royal Mail will know, a big yield is often a sign that the market has lost confidence in a company, earnings are floundering and a cut is just around the corner.

How high is too high? It’s subjective but I’d say anything yielding above 5% requires extra scrutiny. It’s particularly important to check the extent to which dividends are covered by profits (found by dividing earnings per share by payout per share). Anything less than 1.0 should usually be avoided. Dividend cover of 2.0 or more is ideal. 

2. Susceptible to disruption

A company that struggles to compete with newer, nimbler rivals could continue falling in value regardless of how cheap its shares already are. 

A recent example of this would be Thomas Cook. The one-time FTSE 100 member didn’t adapt quickly enough to the fact that only a minority of people physically enter a travel agent to book a break these days. 

If you can’t identify a reason as to why a company will be able to stay relevant and grow profits over the years, then steer clear.

3. Too much debt

Even if a company can still hold its own, too much debt on its balance sheet — perhaps as a result of acquisitions in an effort to boost earnings — can be enough to kill it. This clearly becomes even more likely in the event of a sustained economic downturn.

Before buying into any stock, check its balance sheet and ask yourself whether you’d feel comfortable owning the shares during a recession. Anecdotally, the vast majority of stocks in my own portfolio have net cash positions, which should help them negotiate tough times without issue. 

4. A favourite with shorters

Generally speaking, it’s best to disregard stocks attracting the attention of short-sellers. Based on their usually-very-intensive research, these people are betting big money that the share prices of particular companies will continue falling, at least over the short term. 

There have been many examples this year in which the shorters have got things right: battered challenger Metro Bank, services provider Kier Group and the aforementioned Thomas Cook. All of these were ‘cheap’, based on conventional metrics.

Checking shorting activity isn’t difficult. Simply go to shorttracker.co.uk and enter the relevant ticker.

Price isn’t the most important thing

On their own, each of these indicators might not be sufficient to identify a value trap. Collectively, however, the chances of big trouble rise significantly.

That’s why I’m a big fan of star fund manager Terry Smith’s approach. While not dismissing the importance of buying at a good price, Smith feels identifying great companies is more important. With his Fundsmith Equity Fund having achieved an annualised return of 18.8% since inception, it’s hard to disagree.

The post Absolute bargain or cheap for a reason? How to spot a value trap appeared first on The Twelfth Magpie.

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Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.

Steering clear

On the face of it, housebuilder Persimmon (LSE: PSN) looks a screaming buy, with shares trading at just 7 times forecast earnings and yielding a stonking 12%. Dig a little deeper, however, and some cracks in the investment case begin to appear.

Last night’s Channel 4 Dispatches investigation into allegations of shoddy workmanship, poor customer care and excessive profits at the £6.3bn-cap is concerning for investors. Further complaints could risk the company being expelled from the lucrative Help to Buy scheme that has benefited its bottom line so much over the years and makes up almost half of Persimmon’s sales.

The fact that we’re still no closer to knowing what sort of Brexit we will get at the end of October (assuming we get one at all) is another reason I continue to be wary of cyclical companies such as this.

Should a recession hit the UK and activity in the housing market slow, that ‘bargain’ valuation will quickly disappear and the huge dividend — covered just 1.2 times by profits —  could be in danger. 

Travel pain

Another firm vulnerable to the ongoing uncertainty surrounding our EU departure is holiday operator TUI Travel (LSE: TUI). With a difficult trading environment already forcing the company to issue two profit warnings so far in 2019, Tui also continues to be impacted by the grounding of Boeing 737 MAX planes around the world following two fatal crashes in only a few months. Investors can probably expect more pain to follow if this issue isn’t resolved soon.

It may not be in the same sorry state as industry peer Thomas Cook but, with such an uncertain outlook, I’m struggling to see the attractions of investing when there are so many, less risky income-generating opportunities elsewhere.

The shares have more than halved in value over the last 12 months and now change hands on a little under 11 times forecast earnings. The dividend yield is 6.8% at the current price, covered 1.4 times by profits.  

Slashed payouts?

Third on my list of high-yielding FTSE 100 stocks I’m continuing to avoid is energy supplier Centrica (LSE: CNA). With a yield of approaching 14%, the company is theoretically the biggest dividend payer in the index. As a result of competitors continuing to tempt customers away and onerous pension obligations, however, a slash to the payout looks inevitable.

Of course, I’m not alone in thinking this. Having once predicted it would be reduced by a third, analysts at Credit Suisse now believe a 50% cut to 6p per share is on the cards and could be announced at the same time as the firm’s half-year figures on 30 July. That would leave the stock yielding 6.7%, which some may argue is still too high. 

With the share price now at its lowest point in 20 years, it’s quite possible the market will respond positively once this news is announced and Centrica may experience a brief bounce. Factor in the perpetual threat of political interference, however, and I just can’t see the stock — available at 11 times earnings — as anything more than a value trap. 

The post 3 ultra-high FTSE 100 dividend stocks I’ll continue to avoid in 2019 appeared first on The Twelfth Magpie.

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Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.

Annus horribilis

The management team over at Interserve probably can’t wait to see the back of 2017 – it’s been a truly horrible year for the international support services and construction group. In this ‘annus horribilis’ for the poor old bosses at the beleaguered firm, they’ve watched in horror as investors have exited in their droves to leave the company’s share price decimated after a long and painful 12 months.

Back in February the Reading-based group saw its shares tank as it announced that the anticipated loss from its Energy from Waste (EfW) business was likely to cost £160m, as opposed to the much lower estimate of £70m given the previous year. The markets sliced a third off the company’s value the same day. A week later, and to no-one’s surprise, Interserve shelved its dividend. But that was just the start.

Profit warnings

The shares were to take another tumble in September, when the group gave the first of two profit warnings. Management said that it now expected the outturn for the year to be significantly below previous expectations following disappointing trading during July and August. The share price halved.

A second profit warning in as many months came along on 19 October, with management this time saying that it now expected operating profit in the second half to be approximately half that of 2016. This was accompanied by the revelation that the company was in danger of breaching its debt covenants, and that it was “engaged in constructive and ongoing discussions with its lenders“.

Hollywood disaster movie

But this story has more twists and turns than a Hollywood disaster movie. The very next day Interserve announced a five-year, £227m facilities management contract with none other than the UK government’s Department for Work and Pensions (DWP). And to put another spanner in the works, three days later the group said that it had secured a £140m contract extension with the BBC, until 2023. Now that doesn’t sound like a company that’s likely to cease trading anytime soon.

At around 80p, Interserve is now trading at a massive 90% discount to where it was less than four years ago at 745p, and those who like to view the glass as half full might see the recently awarded contracts and ongoing discussions with its lenders as a reason to be optimistic. Personally, I think the pendulum has just swung in favour of a value play rather than a value trap, and if I’m right there could be huge upside potential. But I must stress, this one is for diehard contrarians only.

The post Is Interserve plc now a classic ‘value trap’? appeared first on The Twelfth Magpie.

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Bilaal Mohamed has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.

To recap, last Tuesday the company revealed that it had agreed new credit facilities and deferrals on some of its debt repayments. In addition to this, the £200m cap announced the sale of most of its UK healthcare business to outsourcer Serco — a business that’s also had its fair share of problems over the last few years — for just over £50m.

Is this sufficient? Hardly. Let’s not forget that the small-cap booked an £845m writedown of construction contracts back in July. Tackling the amount of debt on the company’s books will take a while, during which time loyal holders of its stock won’t get so much as a sniff of a dividend. When you’re not even being paid to be patient, you really have to question whether a business is truly investable. 

Yesterday’s announcement that the company had recruited ex-BAE Systems executive Andrew Davies as its new CEO may have been welcomed by market participants, but few would disagree that he faces an unenviable series of tasks when he officially takes up his new role next April. These include continuing to dispose of Carillion’s assets, attempting to recoup money from historic contracts and overseeing a likely share placement.

These facts, when coupled with the hugely unpredictable share price at the current time, suggest that the Wolverhampton-based firm should only appeal to traders or speculators and not those adopting the Foolish investment philosophy of buying quality companies at reasonable prices and holding them for the long term. 

Carillion’s turnaround plan may have started, but I’m more than content to watch from the sidelines.

Troubled times ahead?

Despite the general resilience of the gambling industry during uncertain economic times and a recent rise in operating profit, another stock I wouldn’t go near right now would be bookmaker Ladbrokes Coral (LSE: LCL). Like Carillion, the newly-merged company carries a lot of debt on its balance sheet. Moreover, the sheer amount of competition it faces from other established high street players and online gaming companies ensures the amount of money spent on marketing and promotions must remain stubbornly high.

But high levels of debt and a hyper-competitive market aren’t the only problems for Ladbrokes Coral right now. New legislation on fixed odds betting terminals could soon have a huge impact on the company’s level of profitability, more so than other bookmakers such as FTSE 100 constituent Paddy Power Betfair, which has a smaller high street presence. Should the government agree to drastically reduce the maximum permitted stake on FOBTs from £100 to £2, as suggested by the Campaign for Fairer Gambling, it doesn’t feel completely unreasonable to suggest that the £2.4bn cap may need to quickly re-evaluate its dividend policy.

With so much uncertainty, I believe investors may better off waiting for the outcome of the government’s triennial review (due any day) before deciding whether the shares are a safe bet. A P/E of 10 times is undeniably tempting but I would suggest that the shares are cheap for a reason.

The post Carillion plc isn’t the only value trap I’d avoid right now appeared first on The Twelfth Magpie.

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Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.

Ready to fall further?

At first sight, £1.2bn cap homewares retailer Dunelm (LSE: DNLM) looks an enticing investment proposition: decent operating margins, a history of great returns on capital employed and excellent free cashflow. With total sales across the group rising 11.4% over Q3 to £255m and a 4.2% dividend yield on offer, what’s not to like?

Delve a little deeper into the numbers in April’s trading update however, and things look less rosy. While online sales are positively thriving — up 20.5% to £55.4m over the last three quarters — the company’s substantial 159-store estate is quickly becoming a burden.

Like-for-like sales at its sites dipped 4.3% over Q3 to just under £191m, continuing a trend that has been apparent since the start of the current financial year. When the figures from the last three quarters (or 39 weeks) are combined, like-for-like sales are down 3.5% or a little below £21m.

Given the seemingly unstoppable migration of shoppers online, I therefore find the company’s decision to continue opening new sites concerning due to the not-insignificant overheads these generate. Dunelm opened two news stores in the last quarter and is “legally committed” to another five.

While some costs relating to maintaining existing stores are to be expected, I’d far prefer the company to concentrate resources on developing its online offering, particularly given its recent acquisition of Worldstores — the UK’s largest home and garden online retailer. With levels of debt continuing to rise (£117m in April), the strategy of continuing to expand its bricks and mortar estate looks increasingly risky.

On balance, I’m not convinced that shares in Dunelm’s are worth holding on to, even if management remains confident that the company will continue to outperform its peers. A valuation of 13 times earnings following a 38% fall in the stock price over the last year may attract contrarians but I suspect things are only likely to get worse over the rest of the year.

Off your bike?

Bike and car parts retailer Halfords (LSE: HFD) is another company I’d consider ditching sooner rather than later and not simply due to the rather sluggish performance of its shares since last year’s shock referendum vote.

A quick look at the company’s financials gives me the evidence I need to justify giving the stock a wide berth. Operating margins, returns on capital and free cashflow have all been falling over the last few years while levels of net debt at the end of the last financial year (£86m) were 80% higher than the year before.  

With earnings predicted to barely grow over the next couple of years and consumers likely to delay big-ticket purchases, I fear for the dividend. As many income investors will know, a large but stagnant yield points to a company treading water. At 5% and barely moving, Halford’s bi-annual payouts could quickly become unsustainable if economic jitters persist.

At 12 times forecast earnings, shares in the Redditch-based business look deceptively cheap, in my opinion, and are best avoided in the short-to-medium term. 

The post Why I’d dump these dangerous retailers appeared first on The Twelfth Magpie.

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Paul Summers has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.

Game over

In November 2014, the shares of Game Digital (LSE: GMD) hit 338p. Fast forward to today and those very same shares have fallen 90%. Just why anyone would consider investing in the high street video game retailer in 2017 is beyond me.

Recent results tell you everything you need to know. In March, the £59m cap announced a 9.1% dip in revenue to £499m over the 26 weeks to the end of January compared to the same period in 2016. Pre-tax profits dived almost 27% to £16.5m and net cash from operating activities fell 61% to £25.7m.

With the popularity of online gaming making traditional consoles look increasingly outdated, I believe Game — which struggles to compete on price with online behemoths such as Amazon anyway — is a company in terminal decline. 

Aside from my concerns about where exactly it hopes to find and retain new customers, a quick look into Game’s financials is more than enough to put me off the company. Operating margins and returns on capital have fallen dramatically in recent years. Free cashflow? Don’t even go there.

Shares may be trading on just 11 times earnings (assuming EPS growth of 1.6% for the current financial year) but Game is one business that — in my opinion — is very unlikely to recover.

Posh flop?

Holders of Laura Ashley (LSE: ALY) surely deserve a bit of sympathy. The shares were trading around 24p this time last year. Today, you can pick them up for just over 10p – making it the sixth worst performing small-cap on the main market.

A quick recap of February’s interim results for the six-month period to the end of December and this kind of performance should come as little surprise. Back then, the company revealed a 3.5% drop in total like-for-like retail sales with pre-tax profits slumping 28% to £7.8m. At a time when any retailer worth its salt is growing digital sales at a furious rate, it’s interesting to note that online revenue remained almost flat at £25.6m (an increase of just £600,000 on the same period in 2016).

Looking forward, the Newtown-based business is expected to post a 52% drop in earnings per share for this financial year. Dividends are unlikely to be covered by profits and I wouldn’t be surprised if the company’s balance sheet — which once boasted a net cash position — becomes even more fragile. Returns on capital, which used to be so high, are falling rapidly. Free cashflow has dropped off a cliff and, thanks to its significant store estate requiring regular investment, I can’t see this recovering anytime soon.

As inflation rises and consumer belts tighten, Laura Ashley looks more vulnerable than ever. On eight times earnings, this presents as nothing more than a value trap.

Bottom line

When it comes to investing, buying cheap doesn’t always work out well, particularly in the ultra-competitive retail sector. For every company that manages to turn things around, you’ve got several more continuing to struggle or falling into oblivion. As far as I can tell, both Game Digital and Laura Ashley are prime examples of the latter.

The post 2 dangerous value traps I’d sell immediately appeared first on The Twelfth Magpie.

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With both banks trading well below book value, are their shares undervalued?

Low Valuations

HSBC’s shares are currently trading at 0.76 times tangible book value (TBV), while those in Standard Chartered are worth just 0.49 times TBV.

This indicates that the market believes the banks’ assets are worth significantly less than what it says on their balance sheets, and this usually means two things: more loan losses are expected to be made, and returns for the banks will likely be sub-par in the near future.

Low Returns

Returns on equity (ROEs) for HSBC have actually been below expectations for some time. They have consistently missed management’s medium term targets over the past 5 years, despite the bank twice lowering its ROE target, from 15-19% to 12-15% in 2011, and again to “more than 10%” in 2015.

In 2015, its actual ROE was just 7.2%, with the bank making a pre-tax loss of $858m in the fourth quarter. The unexpected weakening in the bank’s financial performance could be taken as a sign that its earnings outlook has taken a turn for the worse.

HSBC’s size and complexity means it is beset by higher regulatory and compliance costs than many of its rivals. This has meant that despite the bank’s efforts to cut costs and boost returns, HSBC’s total operating costs have actually risen in recent years, and its cost to income ratio remains stubbornly high, at 66.5%. Having a higher cost structure and carrying more capital means many local banks enjoy a competitive advantage against HSBC, particularly in those markets where HSBC has a smaller presence.

Standard Chartered, on the other hand, has had a great run up until the recent emerging market slowdown. Normalised ROEs have consistently been in the low- to mid-teens for the five years leading up to 2013. Up until recently, the bank had not made an annual loss since 1989, not even during the 2007/8 financial crisis.

But for 2015, the bank reported a loss of $2.36bn, following a near doubling on loan losses, to $4bn. The worst is not over for emerging markets, and earnings will likely stay low for longer, as loan losses continue to rise and revenue growth slows. Looking forward, management expects ROEs will only reach 8% by 2018. That’s a near three year wait for a return which is still sub-par.

Bottom Line

Both banks may seem undervalued on their low price-to-tangible book valuations, but these valuations do actually seem justified when we take into account their low profitability. In addition, as loan losses continue to rise, there are growing fears over a potential dividend cut at HSBC and a further capital raise for Standard Chartered.

With such uncertainty surrounding these bank shares and a weak outlook on earnings, these bank stocks resemble classic value traps to me.

The post HSBC Holdings plc & Standard Chartered PLC: Value Plays Or Value Traps appeared first on The Twelfth Magpie.

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Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended HSBC Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.