It’s no secret that very cheap shares have the potential to be the biggest beneficiaries of a long-term stock market recovery.
Discounted stocks typically offer far wider margins of safety. And while there are never any guarantees for success, the more room for growth, the bigger the capital gains can become.
Buying undervalued enterprises has long been a proven strategy for building wealth in the stock market. It’s the very embodiment of buying low and selling high. Of course, this is often far easier said than done, especially when market conditions are calm.
However, in periods of volatility like those we’re currently experiencing, panicking investors are creating far more opportunities for wiser individuals to capitalise on.
Lower prices mean higher potential returns
When investor pessimism is high, mood and momentum can drive the valuations of terrific companies into the gutter. But this downward pressure is often based on short-term challenges, sometimes even outright ignoring the firm’s long-term prospects.
Providing that a high-quality business can overcome the hurdle that investors are moaning about, a group’s long-term potential can be unleashed. And since, in the long run, stock prices follow the progress of the underlying business, returns on cheap shares can be exceptionally lucrative.
But something that’s easy to muddle up is the difference between price and value. It’s entirely possible for a stock trading at 500p to be cheaper than one at 100p. That’s because the price alone is not enough to determine whether a stock is undervalued. Investors need to be able to compare it against the underlying value of the business.
Determining intrinsic value is a complex process that usually involves building discounted cash flow models. But a popular shortcut is to use relative valuation metrics like the P/E ratio.
By comparing the current P/E ratio to the historical average, investors can get a rough idea of whether the stock is trading at a discount. And then focus their efforts on investigating whether this discount is warranted, or if a buying opportunity has emerged.
Focus on quality
Jumping into any investment without proper research is a recipe for disaster. As mentioned, a discounted stock isn’t necessarily a bargain if the underlying business is compromised.
Most industries operate in cycles. And for many, 2023 is a down period where sales and earnings may even shrink. However, such industry trends eventually reverse, indicating that better financial performance could be on the horizon.
Of course, that doesn’t mean every company can make a stellar comeback. Those who lack the funds to weather the storm may struggle to stay afloat, creating plenty of opportunities for competitors to steal market share. That’s why focusing on the highest quality enterprises is so key to success.
These types of companies can come in many forms. They might have a well-capitalised balance sheet, the flexibility to adapt to adverse conditions, or perhaps even a solid track record of defying expectations.
Such qualities don’t guarantee success. But the probability is certainly higher. And it’s even more elevated if these stocks can be bought at a terrific cheap price.