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Value stocks are a favorite for British investors looking to get the best bang for their buck. In short, these are stocks that are temporarily trading below fair value due to external factors.
The idea is simple: buy these undervalued stocks when they are cheap, hold them when the market recovers, and maximize capital growth. But there is a catch – some stocks are cheap for the wrong reasons, namely: bad management, weak demand or poor performance.
This is where the difference between a real value opportunity and a classic value trap becomes critical. So let’s consider two examples in London Stock Exchange.
Jet2
Up and coming budget airline operator Jet2 (LSE:JET2) is a good example of what a reliable value share can look like. On the surface, it’s exactly the type of business nervous investors would shy away from. It is reflected in the economic cycle, oil prices, consumer confidence, and national politics.
If fears of a recession rise or the headlines turn negative on the move, sentiment can change dramatically and stocks can fall, making them look ‘cheap’ on earnings or cash flow.
But beneath that dynamic, several factors suggest an opportunity of real value rather than a pitfall.
Importantly, it has a diversified model, focusing mainly on package holidays with an integrated airline. This strategy often promotes repeat practice and brand loyalty. Managers also show discipline in managing capacity and routes rather than recklessly chasing growth, which is important when the cycle turns.
This is reflected in its balance sheet, which has been better managed than other peers, giving it resilience in the downturn. So when the market is pessimistic, there is a strong argument for considering stocks at a discount based on the company’s long-term earnings potential.
That’s what a share price is all about: temporary pessimism in a business that still has decent prospects.
Victrex
Now compare that Victrex (LSE:VCT), a stock that is often cited as a potential bull in recent comments. To the screener, it looks pretty negligible – the share price is down almost 70% over five years, even if it’s wide. FTSE 250 little by little he gained.
Dividend yields rose to double digits, which is undoubtedly attractive to income investors looking for high yield opportunities. If you look at just those metrics, it’s easy to label the value of sharing. But focus on the basics and another very concerning story emerges.
The company has been investing heavily in capacity and new projects, but revenues and profits have declined rather than grown. This suggests a negative return on capital expenditure. Meanwhile, competitive pressures and demand have intensified, weak markets and trade tensions are hurting their bottom line.
Now, that higher dividend yield looks more like the result of a falling share price than a thriving money machine. It is fair to say that the payment may not end if the salary does not return.
An important point
There is no guarantee that Jet2 will recover this year. Equally, Victrex can use a strong recovery strategy and reach the top. But when evaluating a stock, it pays to look at all factors.
Right now, if you’re forced to choose between one or the other, I think the Jet2 looks like the better option to consider. As always, within a diversified portfolio to help reduce risk while aiming for higher returns.
