It’s rare for me to be very concerned about a particular company. Yet once every few years, I see something that really makes me want to stay away from a business. Even if the share price has fallen and some are calling it a cheap stock, it doesn’t mean that it makes sense for me to buy it. Here’s an example.
The key problem
The Close Brothers (LSE:CBG) share price is down 72% over the past year. It currently has a price-to-earnings ratio of just 2.84. Usually, I benchmark a stock valuation against a ratio of 10. So a figure below 3 is certainly why I’d refer to this as cheap.
However, I never use that ratio just in isolation when thinking about investment choices. That’s well and good, given that the fundamental situation with the business looks very concerning right now.
The warning flag was raised for me back in October 2023, when a UK Court of Appeal ruled against Close Brothers and other lenders regarding historical motor finance deals. In short, Close Brothers didn’t inform customers that the motor dealers were getting commission for the finance deals that were being done.
The FCA has launched an investigation, which is still ongoing. Yet the size of potential fines is large, with some suggesting the sector could have to pay out £16bn in compensation to customers.
I’m staying well away
The management team at Close Brothers are concerned about impact the FCA decision could have on the business. In the latest trading update it spoke of “the significant uncertainty resulting from the FCA’s review.”
In September, it agreed to sell its wealth management unit for £200m, which will help to boost finances ahead of any potential fine. On top of cutting the dividend, all of these measures are built around trying to build up enough of a buffer.
Yet according to analysts at RBC Capital Markets, the fine for Close Brothers could be as large as £640m. To put this into perspective, the 2024 annual report showed a profit after tax of £100.4m.
I’m not saying a fine of this size would send the company bust. Based on the assets on the balance sheet, it can survive. But it might have a multi-year impact on the firm.
Tempering my mood
Perhaps I’m being too pessimistic. After all, it could turn out that this was all a bad dream and the FCA just decides to give the management team a strongly worded letter and everything just settles down. In this case, I’d expect the share price to leap higher on investor optimism.
Or it could be that there is a fine, but it’s smaller than investors are expecting. This too could see a relief rally in the stock, and anyone buying the shares today might benefit in the short term!
However, I’m a long-term investor and struggle to see Close Brothers recovering from this whole situation for several years. Other investors might feel differently, but without the profitable asset management business, I think it fundamentally needs to reshape the entire business model if it’s ever to be a company that I’d consider investing in.
The post Why I believe this cheap stock is fundamentally doomed appeared first on The Motley Fool UK.
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Jon Smith has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
