It has been a mixed year in the stock market. The flagship FTSE 100 index is close to where it was a year ago, having added just 2% in the past 12 months. But between February and March, and then again from August to October, the index lost almost 10%. That level of loss almost meets the common definition of a stock market correction, which is a 10% decline in a short space of time.
Some shares have done far worse than that. In my own portfolio, for example, Rolls-Royce shares are 21% lower than a year ago, JD Sports is down 41% and boohoo has given up 65% of its value.
How should I respond to the next stock market correction? I will use it to try and build my wealth! Here is how.
How to get rich
As an investor, getting rich is simple — in theory. It involves three elements. I need to find great businesses in which to invest. I need to buy at an attractive price. I also need to invest enough money to move the needle of my finances. If I put a very small sum in, I may increase my portfolio value but it is unrealistic to expect that I would get rich.
Of those three things, two of them are basically constant. Finding great companies and investing enough money involve the same sort of approach, regardless of stock market volatility.
The crucial difference comes when thinking about investing “at an attractive price”. If I can use a stock market correction to buy into the right companies at an attractive price, I could profit handsomely.
How to value shares
But what is an attractive price? If it was easy to tell, I think more investors would get rich.
Take boohoo as an example. I can buy its shares for little more than a third of what I would have paid 12 months ago. Does that mean the business now is worth around two thirds less than it was before? Maybe the selloff has been overdone, meaning boohoo is a potential bargain for my portfolio at its current price. Then again, with falling revenues and tumbling profits, it may be that the boohoo price is not attractive to me at all, even after its steep fall.
To decide what makes an attractive share price, I use a fairly straightforward formula inspired by billionaire investor Warren Buffett.
I consider what profits I expect a company to generate in future. I then compare that to its current valuation (not forgetting its debt, which ultimately will need to be repaid), allowing for the cost of tying up my capital over time. If the current price is markedly cheaper than what I see as the long-term value, I would regard it as attractive.
How I’d handle a stock market correction
That explains how I plan to approach the next stock market correction. I will not start looking around then for attractive companies. The time for me to do that is now, so I can be ready to act when opportunities present themselves.
Instead, I will focus on valuation. Has a fall in prices brought shares I want to own down to what I regard as an attractive price?
