Two reasons why the market might be missing a trick with Royal Mail

Buying quality merchandise when it’s on sale is a stock market strategy used by some of the greatest investors in the world – including Warren Buffett. After the economic turmoil we’ve seen over the past year, there are signs that stocks like Royal Mail (LON:RMG) could fit that bill. But how can you tell?

The Royal Mail share price has moved by -26.4% over the past three months and it’s currently trading at 359.8p.

In uncertain conditions, many investors are keen to buy what they think are cheap stocks – but this can be a mistake. It’s important to know the difference between a genuine bargain and a value trap – and often, the quality of the stock makes all the difference.

The encouraging news is that Royal Mail has at least some of the traits that are often associated with two influential drivers of investment returns: high quality and a relatively cheap valuation.

To understand where they show up, here’s a closer look:

Quality stocks you can depend on

Good quality stocks are loved by the market because they’re more likely to be solid, dependable businesses. Profitability is important, but so is the firm’s financial strength. A track record of improving finances is essential.

One of the quality metrics for Royal Mail is that it passes 9 of the 9 financial tests in the Piotroski F-Score. The F-Score is a world-class accounting-based checklist for finding stocks with an improving financial health trend. A good F-Score suggests that the company has strong signs of quality.

Buying at a fair price

While quality is important, no-one wants to overpay for a stock, so an appealing valuation is vital too. With a weaker economy, earnings forecasts are unclear right across the market. But there are some valuation measures that can help, and one of them is the Earnings Yield.

Earnings Yield compares a company’s profit with its market valuation (worked out by dividing its operating profit by its enterprise value). It gives you a total value of the stock (including its cash and debt), which makes it easier to compare different stocks. As a percentage, the higher the Earnings Yield, the better value the share. 

A rule of thumb for a reasonable Earnings Yield might be 5%, and the Earnings Yield for Royal Mail is currently 25.8%.

In summary, good quality and relatively cheap valuations are pointers to those stocks that are some of the most appealing to contrarian value investors. It’s among these shares that genuine mis-pricing can be found. Once the market recognises that these quality firms are on sale, those prices often rebound.

What does this mean for potential investors?

Finding good quality stocks at cheap prices is a strategy used by some of the world’s most successful investors. But be warned: these factors don’t guarantee future returns and we’ve identified some areas of concern with Royal Mail that you can find out about here.