With the markets still reeling from the recent correction, value stocks are all around. And while there’s no way to predict when the long-awaited recovery will kick in, there are some early signs that it might have already started. After all, the FTSE 250 is up around 10% since the start of November, halfway to returning to a technical bull market. Meanwhile, CPI inflation has dropped sharply to 4.6%, drastically reducing the odds of a recession.
With the economic outlook improving, shares are slowly moving back in the right direction. And if it later turns out that this is indeed the start of a new bull market, snapping up high-quality businesses while they still trade at discounted prices could be one of the most lucrative investments right now.
Finding value opportunities
To capitalise on stock market bargains, investors have to first find them. And sadly, that’s easier said than done. After all, it can be difficult to be bullish on a stock that other investors are being pessimistic about, and dangerous to outright ignore the naysayers.
A lot of companies have been sold off lately as investors have been making panic-driven decisions to try and protect their wealth. But in some instances, a drastic sell-off may be justified. After all, we’re now in a drastically different economic environment than a few years ago.
The last 10 years of cheap debt courtesy of near 0% interest rates enabled plenty of businesses to flourish. But the gravy train has since hit the buffers. And firms that grew overly reliant on cheap debt to fund expansion now have highly leveraged balance sheets that are severely dragging down margins.
Even FTSE 100 companies have been caught off guard by the rapid rise in interest rates. And businesses like Vodafone are having to sell off entire divisions just to reduce their pile of loan obligations.
Unsustainable debt isn’t the only red flag to be on the lookout for. But when exploring beaten-down stocks for potential value opportunities, filtering out the overleveraged firms will help eliminate duds from consideration.
How to use the P/E correctly
One of the most popular metrics to gauge valuation is the price-to-earnings (P/E) ratio. It’s easy to understand why. The P/E ratio is incredibly simple to calculate, and a comparison against the industry average can quickly reveal whether a stock is trading at a discount to its peers. Needless to say, it’s an exponentially faster process than building complex discounted cash flow models.
However, a low P/E ratio isn’t always a bargain. In fact, in many cases, it can be an outright trap. That’s why when stumbling upon a low P/E ratio, investors need to spend time investigating why the stock is being priced so low.
It could be that the business has too much debt, as I just described. But the answer may not always be that obvious. Perhaps a competing firm has just released a new product that’s vastly superior, or could even make alternative solutions obsolete. Or maybe new regulation or changes in a country’s tax system is likely to hamper growth.
The point is that value investors need to know what and where the threats are. And they need to invest only when the potential reward outweighs the risks.
