UK value stocks are back in fashion. Following the recent correction, many top-notch businesses are trading at discounted valuations. And investors who are prudent enough to spot these opportunities right now could reap some lucrative returns in the next few years.
For those saving for retirement, capitalising on today’s cheap prices could drastically improve the size of a nest egg. Investing obviously carries greater risk than keeping cash in a savings account. But the potential for big returns makes it far more worthwhile, in my mind.
The returns to expect
Following the recent interest rate hikes by the Bank of England, savings accounts are finally providing meaningful returns for the first time in over a decade. And earning a near risk-free 5% return on capital is certainly nothing to scoff at.
However, these gains still pale in comparison to the stock market’s 8-10% average annual returns. Even if the lower end of this range is achieved, investing £500 a month for 20 years at this rate versus a savings account could be the difference between £205,520 and £294,510.
What’s more, this performance is only the market average. Successfully picking individual value stocks could propel these gains far higher. Even if the total return only reaches 12%, that’s enough to push the same portfolio to £495,000! And by following the 4% withdrawal rule, this translates into a passive income of £19,800 each year.
Finding winning value stocks
On paper, hitting a 12% return sounds simple enough. But in practice, it can be far more challenging. And a poorly selected collection of stocks could actually end up losing to the market savings accounts and may even destroy wealth rather than create it.
In other words, picking individual stocks carries risks that even professionals can succumb to. In the world of value shares, the biggest threat is falling into a value trap. These are the companies that look like a bargain on the surface but are, in fact, a disaster waiting to collapse.
This is where ratios like price-to-earnings (P/E) have their limits. While these metrics can be handy tools for finding bargains, they don’t explain why a business is priced the way it is. Even panic-selling investors act for a reason. And in many cases, the rapid sell-off of a stock could be very well justified.
So how can investors tell the difference between a winner and a dud? There are a lot of factors to consider in a long line of questioning. But I’ve found that a good place to start is looking at the group’s long-term potential, investigating whether it has the resources to act on it, and then identifying the threats along the way.
The latter is especially important since even a thriving firm today can be disrupted by an innovative start-up in the long run.