The FTSE 250 continues to trend in the wrong direction as small- and medium-sized businesses feel the pinch of inflation and rising interest rates. Yet, in the long run, today’s discounted valuations offer far better value versus buy-to-let properties, in my opinion.
The concept of building a passive income from rental properties gained most of its popularity in the 1990s. But since then, regulation and taxation have made it a far more challenging endeavour. And while it’s still possible to build significant wealth with this approach, investing in shares using an ISA can provide a far better long-term return without HRMC taking a slice of the profits.
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.
Focusing on the long term
With the UK’s flagship growth index currently down almost 10% since the start of the year, a lot of investors are understandably pessimistic. After all, the macroeconomic environment is creating a lot of problems for both households and businesses alike.
Rising interest rates have taken a sledgehammer to family budgets, especially those still paying a mortgage. In turn, lower spending has made growth exceptionally difficult. And for companies with debt-ridden balance sheets, the lack of cash flow expansion has led to profit margins getting squeezed significantly.
There’s no denying that the situation currently looks bleak. But in the long run, this might only be a small speed bump. Economies are naturally cyclical. And while it has been a while since the UK suffered a major downturn, there are plenty of companies with the knowledge and financial resources to weather the storm. And those that succeed could likely find themselves with far fewer competitors, creating new opportunities to secure market share.
For the investors who can identify such enterprises today while the valuations are cheap, potentially explosive returns could be unlocked in the long run.
What to look out for?
There are a lot of qualitative factors that can determine the success of an enterprise. One of the most impactful that I’ve seen is the presence of competitive advantages. Firms that can systematically stay two steps ahead of their rivals are far more likely to thrive. And it’s precisely how companies like Microsoft, Amazon, and Netflix became industry titans in just over a decade.
However, the financials are also important. It doesn’t matter how wide a competitive moat is if there’s no money left to fund it. Therefore, when examining potential opportunities in the FTSE 250 today, I’m paying close attention to cash flow.
Businesses that can continuously expand cash flows in even the most adverse conditions is a winning trait, in my experience. Taking a closer look at debt can also eliminate duds from the equation. Investors should pay attention to a firm’s degree of financial leverage, the maturity date on its loans, and whether they’re paying a fixed or floating interest rate. Don’t forget debt is a tool. And it only becomes problematic when it’s misused.
Obviously, there are a lot of other factors that go into the stock-picking process. But when examining 250 companies, this little checklist can help whittle down the choices to potentially winning enterprises.
