Sometimes it’s a good idea to look for good value in stocks that haven’t done very well on the stock market recently and Royal Mail Group (LSE: RMG) and Royal Bank of Scotland Group (LSE: RBS) both fall into that category.
Letter and parcel post service provider Royal Mail has seen its share price falling around 33% this year, and the RBS share price is about 24% lower than it was in January. On conventional valuation indicators, both firms look attractive at first glance. Royal Mail is changing hands on an earnings multiple just over 11 and the dividend yield sits at 8%. Meanwhile, RBS has a price-to-earnings (P/E) ratio close to 7.5 and the dividend yield is 3.2% rising to 5% next year if things go as planned for the company.
Cheap for good reasons
Many firms have endured weaker share prices since the market correction that started in the Autumn, but I think these two are selling cheap for good reasons. Indeed, Royal Mail is struggling to maintain a declining letter post service that it is obliged to run and the parcel post business is low-margin and operating in a fiercely competitive market. Meanwhile, RBS is fighting its way back from a near-death experience in the credit crunch last decade but operates in a highly cyclical sector, which means that macroeconomic factors could reverse its recovery at any time. Neither firm deserves a higher rating than it has on the stock market, in my view.
I see RBS and Royal mail as risky shares because the underlying businesses are of poor quality. They both have low scores on conventional quality indicators. Royal Mail’s return on capital runs at just 3% or so and the operating margin at just around 1.45%. RBS has a low return on capital of 0.31% and the operating margin is better, at just over 15%, but there is that nagging problem of cyclicality that could knock the figure down at any time.
Never compromise on business quality
Well-known successful investor Warren Buffett advocates never compromising on business quality when picking stocks. And one of the main challenges is that there are many more poor quality businesses around than there are good quality businesses. But he encapsulated his philosophy when he said “it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Indeed, high returns on capital and robust operating margins can be a sign that a firm operates a business with a decent trading niche and strong trading economics. But you won’t find great firms like that trading on P/E ratios and dividend yields of seven or eight, so low valuations can be a sign alerting you that you could be looking at a poor quality underlying business and I think that’s what we have in Royal Mail and RBS today.
I think it is instructional that the grandfather of value investing, Benjamin Graham, abandoned the idea of looking for deep-value situations decades ago, declaring that the investing strategy no longer worked. I think hunting for good value remains a sound idea, but only if it is married with a strong showing on quality indicators. So I’m avoiding Royal Mail and RBS for 2019.