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'Trouble ahead' valuations can be exploited

These companies face uncertainties but some concerns might be misapplied
'Trouble ahead' valuations can be exploited
  • Economic growth and inflation worries are driving ratings
  • Structural qualities of these three companies are worth re-evaluating

A stock with a low PE (or similar profitability ratio) and/or a high yield does not automatically offer good value and high returns for investors. Some sectors and individual stocks are seen as having inherent or time-specific risk or as having permanently low earnings quality, which means that the market feels they ‘deserve’ a low rating and thus do not offer up value. Conversely, these risk and quality concerns can be misapplied meaning that the stock concerned is undervalued.  The shares looked at this week provide an interesting mix of the two scenarios.

Drax  (DRX) – this is a former coal-fired power station operator looking to produce greener energy and help in the decarbonisation process. While it has invested in hydro and ‘clean’ gas, its main thrust has been to replace coal with wood pellets, of which it is a consumer in the vast Drax power station in North Yorkshire and a producer from an array of plants in North America. The big debate here is how ‘green’ is burning timber to generate electricity as trees naturally scrub CO2 from the atmosphere and burning timber releases more carbon than natural gas and, some argue, coal. So, investors need to assess both the core investment and the environmental case here. Good growth is on offer for now, but the pariah status of a coal-burning energy producer seems not to have been fully shaken off. 

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