Stock market volatility has returned over the past week. But over the long run, several sectors in the UK have suffered. In fact, over three years, the FTSE 350 is only up around 2% (up 1% over one year) — clearly that’s not great. Broadly speaking, resource stocks have surged while sectors like banking, retail, travel and housebuilding have suffered.
While this market hasn’t been kind to investors, it does create opportunities to buy top-quality stocks at discounted prices. And, specifically, I’m looking for opportunities in areas of the market that have underperformed.
Here’s what I’m hunting for.
Discounted stocks
Stocks may appear cheap if they’re trading for less than they did a year ago. But I want shares that are actually undervalued. Having said this, I contend that I stand a better chance of finding undervalued shares within bear markets.
But this is where I need to do my research. There’s no best way to value stocks, but I can use both near-term and long-term valuations to generate a good understanding. Near-term valuations include the EV-to-EBITDA ratio or the price-to-earnings metric. And I need to compare these among peers within a sector.
Many websites, including the Hargreaves Lansdown platform, will provide me with this data, so all I have to do is compare stocks in similar sectors.
The discounted cash flow model is an example of a long-term valuation model. If done correctly, I can build a better idea of the value of my investment over a period of time. However, it does require me to make estimations regarding future cash flow, and this can be challenging.
My value picks
Buying undervalued shares and holding them for the long run is generally referred to as value investing. Value investing strategies, such as that of billionaire super-investor Warren Buffett, have constantly outperformed major indices over the past century.
So I’m looking at stocks with near-term valuations below their peers and discounted cash flow calculations that suggest the stock is undervalued.
For example, GSK trades with a P/E ratio of 13, versus a sector average of around 25. However, it’s worth noting that GSK, like many other pharma’s and biotechs, has a substantial amount of debt. So I need to look at the EV-to-EBITDA ratio, which is 6.8 versus a sector average of 15.8.
It’s clear therefore that GSK is undervalued versus its peers. But this could also reflect the risk associated with further Zantac lawsuits, despite a court dismissing cases towards the end of last year.
Meanwhile, a discounted cash flow calculation suggests the stock is undervalued by around 20%. This is clearly positive. But it’s worth highlighting the challenges forecasting cash flow in this sector as future performance is largely dependent on the success of drug and treatment trials.
I recently bought GSK shares, but there are more attractive value picks out there. Lloyds and Barclays are undervalued by 60% and 70% respectively, according to discounted cash flow models. That’s why I’m buying more.
