In the stock market, there are essentially two reasons stocks go up. First, the underlying performance improves, so a stock's revenue, profits, or cash flow goes up. Naturally, you'd expect a company to become more valuable as it gets bigger and earns more money.
The second reason a stock can go up is because the multiple that investors are applying to that stock, based on a figure like revenue, profit, or cash flow, goes up. This is known as multiple expansion when a valuation multiple, such as a price-to-earnings ratio (P/E) expands, and multiple compression when it goes down.
Because of multiple expansion, it's much easier for a cheap stock to outperform an expensive stock, assuming they are otherwise comparable, so it makes sense for investors to look for cheap stocks, especially at a time like this when so many stocks are down sharply.
Two of the cheapest stocks I own today are RH (RH 1.37%), the home furnishings company formerly known as Restoration Hardware, and Children's Place (PLCE -5.04%), the largest pure-play children's apparel retailer, and they both look like great buys. Let's take a look at what each one has to offer.
1. RH: A top performer in luxury home furnishings
Known for its high-end modern furniture like coffee tables and leather sofas, RH stock soared during the pandemic as it benefited from a boom in demand for home goods, like many of its peers. In 2022, however, the company has faced stiff headwinds due to difficult comparisons with last year.
Consumer spending has also shifted away from home goods to categories like travel and restaurants. In fact, RH CEO Gary Friedman was one of the first to call out these headwinds during the company's fourth-quarter earnings call back in the spring.
As a result, the company's revenue in the second quarter was essentially flat at $992 million and adjusted earnings per share actually shrunk from $8.48 to $8.08. Still, underlying profitability remained strong at an adjusted operating margin of 24.7%, showing the business should have no problem managing through the economic headwinds.
Friedman is also one of the most innovative CEOs in retail. He's now in the process of building out the RH brand in new categories like hotels and restaurants, a streaming service based on architecture and design, and even chartered planes and yachts. While that may seem risky, Friedman's bet on a membership model delivered big returns for the stock, and the home-furnishings business has proven it has a loyal following. Therefore, expanding into new categories makes sense.
With the stock price now down 60%, RH trades at a price-to-earnings ratio of just 9, which compares to a P/E ratio of 20 for the S&P 500. That sets up RH stock to rally when the macro environment improves, especially if its new businesses gain traction.
2. Children's Place: An undervalued e-commerce play
Apparel retail is a tough business, and it's not hard to find disappointing apparel stocks. However, Children's Place has long seemed like an overlooked opportunity in the sector.
Following the bankruptcy of rival Gymboree in 2019, Children's Place is by far the largest pure play in children's apparel. The company even took advantage of the Gymboree bankruptcy to acquire its brand and digital assets.
Children's Place is a brick-and-mortar retailer, but over the last decade, the company has reorganized its store base, slowly closing underperforming locations, and invested in the e-commerce channel. As a result, 47% of the company's sales come from the digital channel, as of the second quarter.
Like RH, Children's Place's sales soared last year as it benefited from stimulus checks and the enhanced child tax credit. Recent results look ugly by comparison, as comparable sales fell 9% in the second quarter. However, management said it was on track for the key back-to-school season, and the company is targeting $7 in earnings per share this year, despite the macro challenges.
At its stock's current price, Children's Place has a P/E ratio of less than 5. Given its investments in the digital channel and operational efficiencies, those profits should increase once economic conditions improve, making the stock primed for big gains over the coming years.
