While it may not seem like it, the stock market has had a bit of a rallying cry these past few months. Since October last year, the FTSE 250 is up 10%, with the FTSE 100 following closely behind.
Inflation in the UK continues to be a lingering problem. But it seems the interest rate hikes by the Bank of England are slowly doing the trick. And with the US already in a new technical bull market, it may only be a matter of time before the London Stock Exchange enters a new era of growth.
So the question now is, how can investors capitalise on this long-term trend? Let’s take a look.
What to look out for
The UK’s flagship indices may already be up by double-digits. However, that doesn’t mean the window of opportunity is now closed. Plenty of top-notch UK shares are trading below their intrinsic value as investors remain focused on short-term challenges to growth and earnings.
However, successfully identifying which businesses can overcome these challenges in the long run grants investors the chance to buy at discounted prices. And as every investor knows, buying low and selling high is the ultimate strategy for building wealth.
So what are the things to look out for in this stock market rally? The biggest challenge facing almost every company today is rising interest rates. This decision may be a solid strategy for fighting inflation. But for corporations, it creates a lot of headaches.
The most prominent issue is that debt is getting increasingly expensive to service. And that’s a serious problem for any firm with a balance sheet riddled with loan obligations. With more cash flow gobbled by interest payments, profit margins start feeling the pinch. That’s why many companies like Rolls-Royce are hellbent on bringing their debt piles down as quickly as possible.
Therefore, when looking for cheap UK shares to buy during this rally, I would start by filtering out the companies with excessive amounts of debt. Specifically, investors should compare what percentage of operating profits are being eaten by interest expenses. If it’s growing rapidly, it may not be long before earnings are compromised, dividends cut, and competitors out-innovating products.
Finding bargains
After eliminating overburdened companies from consideration, there’s still plenty of due diligence left to complete. Careful analysis of the financial statements, management team, business model, risk factors, and competitive advantages are just some of the critical aspects of making an informed investment decision.
However, even after identifying some of the best businesses on the London Stock Exchange, that doesn’t necessarily make them the best stocks to buy. That’s because overpaying for even a high-quality enterprise can be a bad investment.
Determining intrinsic value can be tricky during a bull market, requiring nuance and building complex discounted cash flow models. However, multiples provide a far quicker and easier approach during the early stages of a stock market rally.
A rough approximation of value can be determined by comparing the P/E ratio of a stock against its historical average. Providing that the discount is being caused by short-term challenges rather than newly discovered fundamental problems with the business, investors can quickly identify which stocks are potentially worthy of investment.
