One of the most challenging aspects about being a value investor is being able to work out if a company’s shares are cheap for a reason. In other words, finding cheap stocks is not all that difficult, but making an assessment (and being accurate) about their future prospects and share price growth potential is not quite so straightforward.
For example, BAE Systems (LSE: BA) continues to trade on a relatively appealing valuation despite being forecast to post significantly improved financial numbers next year. In fact, BAE has a price to earnings (P/E) ratio of just 11.9 and the key reason for this is disappointing performance last year and also in the current year.
The profit warning released in early 2014 hurt investor sentiment but, with BAE then meeting its guidance, the market seems to have rediscovered a degree of faith in the company’s prospects. And, with BAE being expected to deliver a rise in its bottom line of 5% next year, investor sentiment may continue to pick up – especially since the outlook for key, developed markets such as the US and Europe is improving. Therefore, as austerity gradually becomes less severe and defence budgets are inflated, BAE could continue the run which has seen its share price rise by twice as much as the FTSE 100 in the last five years.
Similarly, Rolls-Royce Holding (LSE: RR) also has considerable future potential. Under a new management team, the company’s strategy is being refreshed and it is conducting a major operational review. However, the introduction of newer engines plus headwinds in Rolls-Royce’s offshore marine markets is causing the company’s profitability to come under severe pressure. For example, earnings are due to fall by 17% this year and by a further 19% next year.
Rolls-Royce trades on a forward P/E ratio of just 15.2 which, for a global industrial business such as Rolls-Royce, is relatively inexpensive. And, with the changes which are set to be made to improve efficiencies and generate improved top-line growth, the company’s future is relatively bright. But, things could get worse before they get better and, therefore, it may be worth waiting for improved performance before buying a slice of Rolls-Royce.
Meanwhile, Tullow Oil (LSE: TLW) trades on a price to earnings growth (PEG) ratio of just 0.1, which indicates that its shares are hugely cheap. Clearly, investor sentiment is very weak as a result of the low oil price but, looking ahead, Tullow Oil is expected to increase its production by around 50% when its TEN development in Ghana comes onstream in mid-2016. This has the potential to significantly ramp-up the company’s top and bottom lines and end the rut which has seen Tullow Oil’s share price tumble from 1600p in 2012 to the current level of 230p.
Clearly, Tullow Oil is relatively volatile and highly dependent upon the price of oil. However, for less risk averse investors it appears to be a worthy purchase for the long term.