November has been a great month for FTSE 250 stocks. The index is up almost 10% as the latest round of British inflation data suggests that the worst of the ongoing economic storm is likely over. If true, then we might be on the verge of the long-awaited new bull market. And that means potentially explosive recovery gains are on the horizon, especially since the index is still down around 25% since its 2021 highs.
A once-in-a-decade opportunity?
Stock market corrections and crashes are a natural part of the investing cycle. But it’s been quite a while since we last experienced a severe downturn like 2022. In fact, last year was the worst performing period for shares since the 2008 financial crisis 15 years ago!
There were a lot of factors contributing to this exceptionally long bull market. Most notable was the unusually prolonged period of near-zero interest rates. After all, this made debt exceptionally cheap, allowing businesses to borrow and fund projects that would have previously been economically unviable.
Today, we’re in a slightly different situation. I think it’s unlikely that interest rates will return to near-zero levels any time soon. But that doesn’t mean growth will be nowhere in sight. Many well-run, high-quality enterprises that prudently capitalised on previously cheap financing have since become financially independent with generative excessive free cash flow.
As such, while competitors struggle to keep up, these thriving businesses will likely continue to take market share and reward shareholders profusely. That’s why buying today while the FTSE 250 is still cheap could be one of the best buying opportunities for a while, perhaps even for the next decade if the new bull market runs for as long as the last one did.
Not every stock is destined for greatness
As previously mentioned, companies were busy capitalising on cheap debt. But not all of them managed to turn themselves into cash-generating machines. And in some instances, the recent interest rate hikes spell disaster.
Over-leveraged balance sheets with insufficient operating profits to cover servicing costs is how bankruptcy starts to creep in. And we’re already seeing multiple leading businesses within the UK’s flagship growth index selling off large chunks of themselves to raise capital and pay down debts.
Needless to say, these aren’t likely to be spectacular investments, especially if their rivals don’t have this handicap. Therefore, when hunting for bargains, investors need to pay attention to the health of the balance sheet and the business in general.
Screening using the price-to-earnings (P/E) ratio can be a quick way to find potentially undervalued businesses. But in some instances, a dirt-cheap P/E may be entirely justified.
Investors can’t just rely on relative valuation metrics and need to take a closer look at the financials, as well as management’s strategy for navigating a higher interest rate environment. Otherwise, they could be walking directly into a value trap, destroying wealth in the new bull market instead of creating it.
