If you are looking for value investments, there’s one section of the market that currently seems to offer more value than most.

The section of the market I’m referring to is the pub sector. Here stocks are trading at mid-single-digit P/E multiples, which in some cases are equal or only slightly more than the dividend yield also on offer.

This kind of valuation discrepancy is only usually seen in severe bear markets. That being said, it is easy to see why the market has adopted such a cautious view of pubcos. The industry is being attacked from all sides.

First of all, pubs are having to cope with rising taxes such as business rates and beer duties. Secondly, the rising minimum wage is also weighing on profit margins. Then there are increasing rents and finally, there’s the cautious consumer attitude to consider. The high cost of buying a pint, coupled with health concerns and shrinking levels of discretionary income means that a night in the pub has become more of a treat than regular occurrence for most consumers.

All of these factors mean that pubcos already razor-thin profit margins are becoming tighter and tighter.

So, considering all of the above, who in their right mind would invest in the sector?

No bad assets

As the Godfather of value investing, Benjamin Graham once said, there are no bad assets just bad prices. The deeply discounted valuation of some of the country’s leading pub groups looks too good to ignore.

Greene King is a great example. At the time of writing, shares in this company are trading at a forward P/E of just 7.8. They support a dividend yield of 6.9% compared to current City growth estimates. Marston’s is even cheaper. This stock trades at a forward earnings multiple of 6.5 and yields 8.3%. Ei Group plc, formerly Enterprise Inns plc, trades at a P/E of 7.7 and a price to tangible book value of 0.6.

Even though there are plenty of headwinds facing the pub industry, there is a lot of bad news already factored into these valuations. Yes, the outlook for the industry could deteriorate further, however, a mid-single-digit earnings multiple already implies the market is not expecting these companies to grow for the foreseeable future.

What about the dividends?

Here the cash flows tell a different story. When evaluating a company’s dividend potential, I like to use its cash flow numbers rather than profit, as these generally tend to present a more realistic view of finances.

For the fiscal year ending 30 September 2017, Marston’s dividend per share cost the company £44m. During the same 12 month period, it generated £213m in cash from operations, more than enough to support the payout. The same is true for Greene King. For the fiscal year to 29 April 2018, the group generated £266m cash from operating activities and paid out £103m in dividends.

The bottom line

Considering all of the above, to me the UK pub sector looks attractive. But rather than trying to pick out just one of these businesses, I believe the best bet might be to buy four or five stocks. This way you can take advantage of the sector’s low valuation with limited exposure to any single business if one should fail.

Disclosure: The author owns no stock mentioned.

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