The FTSE 100 hit a new record high this month as the stock market continued to bounce back from the 2022 correction. But not all UK shares have been so fortunate. In fact, looking at the FTSE AIM 100, the small-cap index is still down around 36% since the correction started.
Yet, in recent weeks, this downward momentum seems to be changing course. History has demonstrated countless times the power of investing during periods of volatility. While it can be risky, some of the best returns are achieved during a stock market recovery. And this process may have just started for British small-caps.
Buying opportunities like this are pretty rare. Don’t forget it took more than a decade following the 2008 financial crisis for investors to have another chance to buy UK shares at massive discounts. And it may be another decade before this opportunity emerges once again.
Capitalising on the small-cap recovery
Small-cap stocks have a reputation for being risky, especially during economic turmoil. And it’s pretty understandable why. The small scale of these enterprises usually means fewer internal financial resources are available to achieve growth. As such, most depend on external financing through debt or equity.
Following the Bank of England’s interest rate hikes, the cost of capital is climbing. And for some small-cap UK shares, this could spell the end of the line. However, not every business is in the same basket.
Looking through the constituents of the FTSE AIM 100, plenty of businesses are already self-sufficient. Some have a large cash war chest to keep operations running throughout this storm, while others are cash-flow-generating machines.
These latter two types are what investors should be focusing on when searching for buying opportunities. Of course, it’s essential not to forget about other critical factors when picking individual stocks. A healthy balance sheet, a solid business model, talented management, and competitive advantages are especially important when evaluating smaller businesses.
Buying UK shares has its risks
Even if an investor successfully identifies Britain’s best undervalued small-cap stock, it’s entirely possible that the share price will continue to plummet.
While inflation seems to be steadily cooling off, there remains a high degree of economic uncertainty within the UK. And with many investors still on edge, rational thinking might be rare to come by. Don’t forget in the short term, the stock market is driven by investor sentiment, not business fundamentals. And should the economic climate take a turn for the worse, cheap UK shares might get even cheaper.
For investors seeking to capitalise on volatility, this risk is largely unavoidable. But it can be mitigated. By ensuring a portfolio is diversified across multiple businesses in multiple industries, the attrition of one sector tanking can be diminished.
Furthermore, deploying a pound-cost-averaging buying strategy can also be a powerful tool. By spreading investments over several months, investors will have the capital to take advantage of any potential further price declines.
