Over the next four years, I anticipate adding quite a few cheap stocks, otherwise known as value shares, into my investment portfolio. I already hold a few, such as National Grid and Persimmon, as well as the investment trust, Merchants Trust.
Value shares tend to perform better during any period of inflation
As a general rule, value stocks perform better in high inflation periods and growth stocks perform better during low inflation.
Some experts are warning inflation will exceed 2% by the end of this year. That would be a big rise from now and would likely have an effect on the performance of growth shares versus value shares.
Overall, it’s unclear if, or when, inflation could rise significantly. What is more clear is that cheap stocks are a better hedge if it does occur.
Cheap stocks provide more margin of safety
Given there may be a reversal in the fortune of many growth shares, I’d plump for cheap stocks because there’s a greater margin of safety.
Buying shares with price-to-earnings ratios that are below 15 – a level that is often seen as separating undervalued shares from the rest – offers some protection against any downgrade in outlook or earnings. Shares on sky-high valuations should, and often do, fall much harder on any bad news.
I think Benjamin Graham, the inspiration for legendary investor Warren Buffett, was correct to say valuation and a margin of safety are very important.
Cheap shares have underperformed
Despite the low valuations, cheap shares have underperformed growth shares in the low-interest rate, low-inflation economic conditions we’ve nearly continuously had since the financial crash. The stock market crash of 2020 still means there are opportunities to pick up cheap UK shares.
For me, the historical underperformance of value shares versus more racy and highly-rated growth stocks isn’t off-putting. While I may add some modestly valued growth stocks to my portfolio, many of my new stock picks over the next four years to 2025 will be cheap stocks.
The thing to watch out for when it comes to investing in cheap shares though is, value traps. This is where a share appears cheap but actually, the valuation is low because the business is worsening. That could well mean that the share price will fall much further. A low P/E doesn’t in itself make a share worth buying. I’d want to get a bigger picture and understanding before committing my money to a value share.
That’s why I’d make sure to look at revenue and operating profit growth and how a company compares to the competition. I’d also look at whether the industry is growing or facing challenges. There are also many other considerations to take into account but these serve as a starting point.
The bottom line is, as always, I’ll research shares thoroughly before investing, even if they are a cheap stock.
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Andy Ross owns shares in National Grid, Persimmon and Merchants Trust. 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.