Not all stocks trading on cheap earnings multiples turn out to be good investments. Let me explain why I think one current FTSE 250 'bargain' and one popular FTSE 100 pick could be dire disappointments for investors.
How the Mitie has fallen
Outsourcer Mitie(LSE: MTO) issued a profit warning in September, another with its half-year results in November, and a third in a trading update earlier this month.
Chief executive Ruby McGregor-Smith departed shortly after delivering the half-year report, and the departure of finance director Suzanne Baxter was announced on the same day as new chief executive Phil Bentley delivered the third profit warning.
However, despite the hit to this year's financials and boardroom upheaval, the consensus among City analysts is for a significant earnings recovery for the year to March 2018. And with Mitie's shares at 200p, over 30% down from their 52-week high, the prospective P/E is 11.5 -- well below the FTSE 250 average of around 18.
Significant downside risk
I think there's a high risk of Mitie's earnings forecasts being downgraded, but the balance sheet is perhaps an even bigger concern. Net assets at the half-year end stood at £225.3m (65p a share), which makes a share price of 200p look way too high to me. Worse still, strip out goodwill and other intangibles and you're left with net assets of minus 56p a share.
On the day of the November half-year results, CEO-elect Bentley purchased £3.6m of shares, but I think he may rue his haste. Alongside the January profit warning, he announced that "the board is undertaking a balance sheet review" which will include consideration of the potential impact of new revenue recognition guidance under International Financial Reporting Standard 15.
I've long shared the suspicion of some analysts that Mitie accounts aggressively for revenue. With new-broom Bentley saying in January that he's already identified £14m of charges after taking "a more conservative judgement on contractual positions", I fear the balance sheet review could be a case of -- in Warren Buffett's words -- "You see a cockroach in your kitchen; as the days go by, you meet his relatives".
However, even if I were to dismiss the possibility of a balance sheet bloodbath, I'd be bearish on the shares purely on the basis of that huge premium to net assets as the balance sheet already stands.
Anaemic long-term performance
Marks & Spencer isn't going through the acute stress that Mitie is suffering. Under new chief executive Steve Rowe, the FTSE 100 favourite is simply embarking on the latest in what seems like a never-ending cycle of attempted multi-year costly transformations to set the business on the path to long-term sustainable growth.
There have been more false dawns than I care to remember. The anaemic long-term performance of the company is well illustrated by the dividend's compound annual growth rate of less than 2% over the last two decades.
Arguably, on a P/E of 11.7 and with a dividend yield of 5.4%, M&S is cheap at a current share price of 340p. However, I find it hard to dismiss the company's uninspiring 20-year record.
And as to the next 20 years, I would ask: if you were going to design a retail operation to thrive in the coming decades, would it look like M&S?
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G A Chester has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.