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How can you tell when an investment is 'cheap' - and where can investors grab a bargain now?

Investors know they have a better chance of good returns buying 'cheap' - a term investment experts use when they see the potential for particular assets to grow.

But how do you work out whether something really is cheap? And is bargain hunting necessarily the best investment strategy? Cheap might mean good value - but you can also end up with a stinker, while something a little bit more pricey is really taking off.

We asked financial experts Patrick Connolly of AWD Chase de Vere, Darius McDermott of Chelsea Financial Services and Adrian Lowcock of Hargreaves Lansdown to explain the measures they commonly use to judge whether investments are cheap or expensive.

They also offered their opinions on whether the top deals around right now - Europe, Japan and commodities - are worth buying.

Cheap as chips: Europe, Japan and commodities

How do you measure cheapness?PE ratio (price divided by earnings)

 

This can be used to measure the historical cheapness of a stock, a sector or an entire market - the lower the PE the cheaper it will be.

McDermott says: 'If for instance the PE of the FTSE All Share is 12 over time and the PE today was under that you could say it is cheap on a historical basis.

'It's a simple way of looking at value measured versus history. But you have to beware of using such a measure on its own.'

Adrian Lowcock of Hargreaves Lansdown cites the example of the bank sector, which had a historically low PE in 2007-2008 - but the outlook going forward was 'pretty shocking' because of the financial crisis.

  More... Investors brave the storm and dive into Europe. Are European funds a bargain? How to tell if a share is good value: Five tips for finding out if a stock is a winner or a dud DIY share dealing: cheap flat-fee service for just £12.50 Get a free guide to investing Isas from Hargreaves Lansdown

Price to book ratio (the price of companies versus their assets)

Sometimes companies are worth less than their net assets due to a negative outlook on a region, or a business and its management, says Lowcock.

You can analyse the historical average of price to book in comparison with today's price to book.

Relative value compared to other asset classes

LOW COST ACCESS TO INVESTING

Actively-managed funds need to pay a fund manager to select stocks, pushing up the costs. Index trackers, on the other hand, aim to follow a stock market's fortunes based on a computer programme.

It's far cheaper. The best trackers levy fees of less than 0.5 per cent a year compared to, for example, funds that may come with a total expense ratio of 2.5 per cent plus.

The effect of charges amplifies over the years and can leave a big dent in your final savings pot, although the managers argue that you are paying for their skill in outperforming the market. Unfortunately most of them don't and it's difficult to predict which ones will excel.

Investors could also consider exchange-traded funds, which are more easily tradeable and are sometimes cheaper than trackers.

Read more here about buying ETFs.

Equities look good value against corporate and government bonds and commercial property right now - making them the 'last man standing', says Lowcock.

But be careful when drawing such comparisons among assets.

'It could still be expensive but just cheaper than something else that is expensive,' says Connolly.

Underperformance

Analysing the historical performance of a fund sector or region is another way of measuring cheapness.

'Those that have underperformed over past few years are cheaper than those that have overperformed,' says Connolly.

'Many investors look at performance tables and buy those that are at the top. There is a strong argument for looking at the tables and being more inclined to buy what is at the bottom.'

Level of income produced

This measure can be used on fixed-income investments - corporate and government bonds - plus dividend-producing equities.

A higher level of income makes an investment better value or cheaper, while a lower level of income makes it more expensive.

Does cheap mean good value - or a bad investment?

What is cheap right now is high risk and unpopular, says Connolly. Assets perceived as safe - such as investment grade corporate bonds, or dividend-producing stocks - are expensive.

'There is often a thin line between cheap and poor quality. It can be hard to tell the difference,' he says.

'Lots of bad investments are cheap today. It's a difficult call. If you are buying cheap today there is a good chance you are buying poorer quality.'

NOT CHEAP - BUT POTENTIALLY GOOD VALUELowcock recommends:

US small cap: Legg Mason US Smaller Companies (Minimum investment: £3000. TER: 1.86 per cent)

Asia: Newton Asian Income (Minimum investment: £1000. TER: 1.66 per cent)

UK: Liontrust Special Situations (Minimum investment: £1000. TER: 1.93 per cent) 

'You need to watch that carefully. If you get a bounce or pick up you may need to consider getting out.'

This means reviewing something you bought cheap if it starts doing better, or you might find yourself left with a poor quality investment that isn't cheap any more, he explains.

Connolly also advises investors to focus on long-term asset allocation, without trying to trade in and out too frequently.

Among equities right now, Japan and Europe are cheap, while Asia Pacific, emerging markets and the UK are fair value, and the US is expensive, according to Lowcock.

But this doesn't mean you should dismiss the US - you should still look at the opportunities there, he says.

'The US looks expensive but there is a reason - it has earned that right. It has a more robust recovery, it has dealt with its housing problem, it has got some growth, it has dealt with the banking crisis.'

Lowcock says the US has a history of reinventing itself and good capitalist companies that have potential to grow and develop, so it is currently worth looking at the small and mid cap space.

'The US tends to have a lot of great companies that can come from nowhere very quickly. Google and Facebook were barely around a decade ago,' he points out.

What's cheap now? Europe: Threat of euro collapse hangs over investments

European shares might be cheap but the Cyprus banking crisis and the Italian political stand-off have shown how vulnerable they can be to fresh shocks.

Investors have shown an inclination to give European funds another chance lately - they were the second most popular buy after global emerging markets funds in January, according to Investment Management Association figures.

But given the latest brutal headlines and ongoing risk of a single currency collapse, Europe looks set to remain unpopular - and cheap - for some time to come.

'Europe is still on a comparative basis cheap,' says Patrick Connolly of AWD Chase de Vere. 'But it's still a long way from being resolved. We have seen the trouble in the past week or so with Cyprus. There may well be other problems.'

Darius McDermott of Chelsea Financial Services says his firm tipped Europe as the market to buy at the start of 2012.

'If you invest when everything looks rosy a lot of the good returns have been made,' he points out.

European returns have started to bounce back. Funds in the IMA Europe Excluding UK sector have seen growth of 25 per cent over five years, 18.1 per cent over three years and 19.6 per cent over one year.

Recent performance has also shown strength, with a gain of 17.6 per cent over six months and 11.2 per cent over three months, although just 0.6 per cent over the past month.

WHAT IS TER?

Total Expense Ratio or TER is the benchmark of fund running costs which is the current best estimate for taking all the administration and dealing charges into account. The bigger it is, the costlier the fund is to run.

European fund tips

Connolly recommends:

Henderson European Growth (Minimum investment: £1000. Total Expense Ratio: 1.76 per cent)

JPM Europe Dynamic (Minimum investment: £1000. TER: 1.68 per cent)

Threadneedle European Select (Minimum investment: £2000. TER: 1.69 per cent)

Lowcock recommends:

Jupiter European Special Situations (Minimum investment: £500. TER: 1.80 per cent)

McDermott recommends:

BlackRock Continental European (Minimum investment: £500. TER: 1.69 per cent)

Threadneedle European Select (see above).

Japan: Decisive election and stimulus could finally trigger recovery

Years of stagnation mean Japanese shares are still cheap, but some investors are sensing an opportunity following the election of a gung-ho new leader in December.

The incoming government has embarked on a stimulus drive, and is preparing to sweep aside the old guard at the Bank of Japan who are too worried about inflation to do anything radical about the economy. The value of the yen has crumbled and the stock market has rallied in response

McDermott says the election of a new prime minister, who has a really strong mandate to make Japan more competitive, is the kind of catalyst to look for when taking a risk on an unpopular investment.

But Lowcock warns that Japan has looked cheap on its current PE ratio and price to book levels (see box above) time and and again.

Opportunity: Years of stagnation mean Japanese shares are still cheap

'We have been here many times,' he cautions.

Connolly says: 'We are still wary on Japan. You can make a case that is is cheap, but Japan has had a lot of false dawns.

'People say "it's different this time", and in the past it hasn't been.

'To our mind the risks are equal to the potential benefits.'

Returns have nevertheless been looking up. Funds in the IMA Japan sector are showing growth of 33.2 per cent over five years, 11.3 per cent over three years and 13.6 per cent over one year.

On a six month basis, they are up 23.3 per cent, over three months up 19.2 per cent, and in the past month up 7.2 per cent.

Investors in Japan should bear in mind currency risks - the government is actively trying to drive down the value of the yen to make exports cheaper.

You can buy Japan funds which are 'hedged' to strip out exchange rate movements, but these can be more volatile and might not suit all investors.

Japan fund tips

Connolly recommends:

Schroder Tokyo (Minimum investment: £1000. TER: 1.66 per cent)

Aberdeen Japan Growth (Minimum investment: £500. TER: 1.62 per cent)

Lowcock recommends:

GLG Japan Core Alpha (Minimum investment: £1million. TER: 1.66 per cent) If you have less to invest than this, you may be able to do so via a fund platform or financial adviser.

McDermott recommends:

GLG Japan Core Alpha (see above)

Jupiter Japan Income (Minimum investment: £500. TER: 1.76 per cent)

Gold miners/commodities: Prices have come adrift from value of gold High risk: Gold miners' shares have continued to fall while gold price has held up

Commodity stocks and investment funds have been been hammered over the past few years, says Connolly.

'They are high risk and perceived to be high risk - and investors have been ignoring risk.'

He also says that investors now tend to buy gold or gold Exchange Traded Funds [ETFs] rather than gold shares.

'What you usually see is the price of gold shares highly correlated to the price of gold. In past few years that has not happened. Gold miners' shares have continued to fall,' explains Connolly.

To investors attracted to the sector for its cheapness, he is willing to recommend a fund but cautions that it is high risk and perhaps one to drip-feed money into slowly in order to smooth out volatility.

Commodity fund tip

Connolly recommends:

JPM Natural Resources (Minimum investment: £1000. TER: 1.68 per cent).



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