At the risk of being overly simplistic, I propose there are two kinds of absurdly cheap stocks: those poised to create value long term and those that will likely destroy value. These two kinds of companies might look the same from a valuation perspective. But valuation metrics largely look backwards. By contrast, investors must look forward.
Brazilian financial-technology (fintech) company PagSeguro Digital(NYSE: PAGS) and home furnishings retailer Williams-Sonoma(NYSE: WSM) are two absurdly cheap stocks that I believe can create value for their shareholders long term. Here's why.
1. PagSeguro
Certainly a high-growth, profitable company wouldn't have a cheap stock, would it? Well, perhaps you haven't looked at PagSeguro. It's all of those things right now.
In local currency, PagSeguro's revenue was only up 9% year over year in the first quarter of 2023. But in 2022, it was up 47% from 2021, reaching $2.9 billion. The company offers a comprehensive list of financial services, including payments, banking, and loans. And it's particularly excelling in payments, going from 1% market share in 2016 to 11% market share in 2022.
Having had its initial public offering (IPO) in early 2018, PagSeguro has been profitable every year since going public, which is a nice, consistent track record. And indeed, the company's net income in 2022 was its highest ever at $288 million.
Since it has profits, PagSeguro can be evaluated on a price-to-earnings (P/E) basis. As of this writing, the stock trades at a P/E ratio of just 10.7 -- a steep discount to the average valuation of 23 times earnings for the S&P 500.
S&P 500 P/E Ratio data by YCharts.
With 28.7 million clients for PagBank, PagSeguro is already the second-largest neobank in Brazil behind Nu. But considering Brazil's population is over 218 million, there's still plenty of room for growth.
Furthermore, consider that only 55% of Brazil population uses cards to make payments compared to over 85% for the U.S. and over 90% for the U.K. and Canada. It's only logical to assume that non-cash payments will increase in coming years in Brazil, and PagSeguro stands to benefit tremendously.
PagSeguro gives investors growth and value in one stock. But cheap stocks are typically cheap because of investors' doubts. In this case, I believe the market is uncertain regarding Brazilian politics and its economy. Moreover, the company's loan portfolio is growing, adding a layer of risk if borrowers don't pay back the loans.
Still, given its growth opportunity, I believe PagSeguro stock is cheap enough to be worth the risks.
2. Williams-Sonoma
If PagSeguro is cheap at 10.7 times earnings, Williams-Sonoma is a downright bargain at 8.4 times its earnings. But as I said, cheap stocks naturally face doubts from investors. Therefore, I should explain the issue with this investment.
I believe the market doubts the sustainability of Williams-Sonoma's operating margin. According to management, it expects at least a 15% operating margin over the years to come, which sounds reasonable at first considering its margin was 17% in 2022. But that's a historical anomaly, as the chart below shows.
WSM Operating Margin (TTM) data by YCharts.
Over the last decade, an operating margin between 8% and 10% has been far more common for Williams-Sonoma. And indeed, the company's operating margin fell to 11.4% in Q1 2023 -- well below what management calls its floor.
According to Williams-Sonoma's management, the improvement of its operating margin over the last few years is the result of permanent, structural change in the business. One of those structural changes is a higher percentage of e-commerce sales. But the timing of the surge in e-commerce sales feels related to the COVID-19 pandemic. Therefore, it seems plausible that Williams-Sonoma's e-commerce sales could slip further, and operating margins could consequently regress to more normal levels.
I believe this is why Williams-Sonoma stock is so absurdly cheap: Investors don't believe elevated profits can continue. It's a fair doubt.
Here's the thing: Williams-Sonoma doesn't need an operating margin over 15% to create long-term value for its shareholders. Even if its margins contract back to 10%, it will still be earning an annual operating profit of close to $1 billion. And that's plenty of cash to keep rewarding shareholders with share repurchases and dividends as it has in the past. The chart below shows the long-term pattern here.
WSM Average Diluted Shares Outstanding (Quarterly) data by YCharts.
With a long operating history, profits, and zero long-term debt, Williams-Sonoma is a stock with little downside. If the company's operating margin takes a step back, it can still create value, just at a slower pace.
However, if management is right and 15% is the new normal for this business, then the stock is absurdly cheap today with a market capitalization of just $8.3 billion. Consider that it returned over $3.2 billion to shareholders from 2018 through the end of 2022. It could potentially return even more to shareholders over the next five years if its operating margin remains elevated.
Again not all cheap stocks are in as strong of a financial position as PagSeguro and Williams-Sonoma -- these two stand out from the crowd. And moreover, both companies have viable paths to creating value for shareholders, which is why I believe both are worth a $500 investment today.
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Jon Quast has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends PagSeguro Digital and Williams-Sonoma. The Motley Fool has a disclosure policy.
