Perhaps the best time to look for cheap shares is after a stock market crash. As the FTSE 100 is down 22.6% in 2020, I’d look for shares to buy inside a tax-free ISA for capital gains and a passive income.
Cheap shares: safety first
When hunting for cheap shares in great businesses, I often focus on the FTSE 100. That’s because many Footsie companies meet my ‘SLR rule’, as they offer ‘Safety, Liquidity, and Returns’ (generally in that order).
However, one danger awaiting value investors is the dreaded ‘value trap’. These cheap shares just keep getting cheaper, often because their underlying businesses are not in good shape. As billionaire investor Warren Buffett remarked, “Price is what you pay. Value is what you get”.
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Cheap shares: big can be beautiful
Using my SLR rule, most of my stock picks are large corporations. Indeed, it’s rare that I venture outside of the FTSE 350 in search of cheap shares. That’s because I prefer to invest in established, well-managed companies with commanding market positions.
Hence, I’m a fan of mega-cap shares – stocks in the UK’s very largest companies. While many mega-cap firms’ share prices have been hammered due to Covid-19, their fundamental businesses are holding up pretty well.
I think Tesco qualifies as a FTSE 100 value share
Warren Buffett also warned investors, “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years”.
When I look at UK supermarkets, Tesco (LSE: TSCO) stands out as the pick of these cheap shares. Having owned Tesco during its heyday (before the 2007–09 global financial crisis), I know how powerfully it can generate revenues, cash flow, and profits.
Alas, over the past five years, Tesco shares have been a disappointment for shareholders, as the share price is up just over a tenth (11.4%). That’s a scant return of just over 2% a year (and hardly better than a savings account). However, Tesco stands out among cheap shares because it’s coping well with the coronavirus, while evolving to face the future.
Today, Tesco shares trade at 211.78p, down 13.2% in a year. This values the UK’s #1 supermarket at £22bn. Tesco’s current share price is just 4% above its 52-week low of 203.7p, set on 23 March. Furthermore, Tesco shares traded above 260p in mid-December 2019, so they have dropped close to a fifth from this peak.
Historically, Tesco shares have indeed been cheaper, but the supermarket has also been in worse shape at times. Tesco’s stock trades on a price-to-earnings ratio just above 20, for an earnings yield of 5%. But Tesco’s main attraction for me is its quarterly cash dividends, which produce a dividend yield above 4.5% a year.
In addition, as part of its ongoing evolution, Tesco is selling its Thai and Malaysian ventures. This sale, expected before the end of 2020, should result in a £5bn payout to shareholders. That’s almost a quarter of Tesco’s current market value.
For me, Tesco stands out among cheap shares for its resilience during Covid-19, its generous cash dividends, and its commitment to return capital to shareholders. That’s why I’d buy its shares today inside a tax-free ISA for future capital gains and a growing passive income!
