2 Quick Ways To Spot A Cheap Share

Published in Investing Strategy on 2 September 2010

To find decent stocks, you don't have to burn the midnight oil.

You can spend a lot of time looking for cheap shares. Fancy computer screening techniques, hours poring over financial reports, evaluating ratios such as price to book value -- you name it, and there are plenty of people out there doing it.

Personally, I'm not a great fan of complex screening techniques, and recently had to enlist the help of fellow Fool Padraig O'Hannelly to run even a quite basic screen. After a few abortive forays on my own, I gave up. Life is too short. But thanks anyway, Padraig -- the fault, I'm sure, lies with the pupil, not the teacher!

So what do I do?

First, let me pass on a piece of advice from Warren Buffett -- even though I've seen recent comments from some of you suggesting that we Fool writers refer to the fellow too often.

Buffett, it turns out, reckons that most private investors -- and certainly those starting out -- would be better served by investing in index trackers, and reinvesting the dividends in more units of the same. ('Accumulation units', in other words.)

In short, build up a decent sum of capital in trackers or index tracking ETFs, and only then start looking at shares. It's sage advice -- and no wonder the chap is often referred to as the Sage of Omaha.

And when you do start looking for cheap shares, as I remarked earlier, the complexities can be daunting. So here are two rough-and-ready ways to get going.

P/E and yield

I'm a fan of shares that pay an above average dividend, and just as firm a fan of shares that offer a P/E that's well below the market average. And when those two traits are combined, I start to take an interest.

I'm not going to go into the complexities of calculating P/E and yield. Most of you know what they are, and in any case, there are plenty of explanations here on the Fool site. The key thing is simplicity: even a broadsheet daily newspaper will list shares' P/Es and yields, and a quick scan will highlight opportunities for further investigation.

And that further investigation, of course, is important: on their own, an attractive P/E and yield are only part of the story, not the whole tale.

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What I've bought

Recently, I've bought into two shares offering promising P/Es and yields. With the FTSE 100 as a whole on a P/E of 13.2 and a yield of 3.5%, I've purchased BAE Systems (LSE: BA) on a forecast P/E of 6.8 -- half the market average -- and a forecast yield of 5.7%.

I've also bought into GKN (LSE: GKN) on a forecast P/E of 10.4, as I reckon it's ripe for a rebound. (The company has only just resumed paying a dividend, so the yield figure for 2010 is artificially low: 2011's forecast of 4.1%, though, is still market average-beating.)

I've also topped up on Aviva (LSE: AV), which has a forecast P/E of 6.3% and a forecast yield of 6.9%. And I've topped up on Tesco (LSE: TSCO), which is also looking cheap. Need I say more?

Buying into bungee jumpers

Another easy way to spot a share worthy of investigation is to look for market over-reaction to bad news.

Note the phrase 'over-reaction', though, and for the complete avoidance of doubt, let me once against stress the word 'over'. In short, this isn't about catching falling knives, or buying into businesses that are heading for the rocks, big time.

But crisis plays and sudden adverse changes on sentiment can massively affect the share prices of otherwise very viable businesses -- the trick is to try and separate the bungee jumpers from the lemmings.

BP (LSE: BP), for instance, will most likely be a bungee jumper. A share price of 300 pence had 'buy me' all over it, in my view. As an existing holder, I didn't, preferring to put the money into GKN, instead -- which had already suffered its own precipitous decline as the recession took hold. Likewise Aviva.

Down, then up

More recently, the market threw up two other likely bungee jumpers. One is own-label detergent specialist McBride (LSE: MCB), which I wrote about recently when the company issued a profit warning, promptly seeing its share price plunge from around 180 pence to an intra‑day low of 112 pence.

Yet there's nothing fundamentally wrong with the business: a lemming it most certainly isn't. Manufacturers of competing branded products are lowering prices to retain market share, in short, and margins are tight as raw material prices inch upwards.

Today the company issued its full year results, which has seen the shares -- already strongly recovered -- rise a further 10% at the time of writing. Investors buying in at the time of the profit warning in early July would have been up 40% in two months.

And I strongly suspect there's a similar story lying in wait for quality IT high-flyer Micro Focus (LSE: MCRO), which has also experienced adverse reaction to a profit warning. In early August, announcing that it had failed to close some expected deals, the company saw its share price fall from 419 pence to 277 pence.

Like a bungee jumper, I strongly suspect that it won't test that particular low again. And neither, I suspect, do its directors, who have been buying in like -- well -- lemmings.

More from Malcolm Wheatley:

Malcolm holds shares in Aviva, Tesco, GKN, BP and BAE Systems.

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The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

jaizan 02 Sep 2010 , 9:46pm

PE ratios are not complex.

Also, they are an important measure, but it's also essential to also take into account the state of the balance sheet.

Floyd3592 21 Nov 2010 , 2:52pm

I love the idea of a bungee jumper and looking at the prices of these shares described as such in late november they have indeed "bungeed" back up. So how does one decide on a bungee especially if one doesn't have the knowledge or the time to do the trick in determining if it's a bungee or a falling knife. Could Malcolm post monthly potential "bungees" perhaps even rating them in terms of "bungee potential"?

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