With the UK’s economic outlook improving with each passing month, cheap stocks are starting to recover from the recent correction. As such, the number of huge bargains is starting to dwindle.
Of course, there will always be more buying chances in the future. But making the most of the remaining ones today could really bolster my portfolio’s performance over the next three to five years. And that’s not the only advantage.
So let’s explore the potentially explosive benefits of grabbing cheap shares today, as well as the risks that come with it.
A wider margin of safety
One of the core concepts of billionaire investor Warren Buffett’s strategy is the margin of safety. After estimating the intrinsic value of a business, Buffett applies another discount based on the risks and uncertainties around the underlying business. That way, if his estimate is off, the margin of safety provides some protection against accidentally paying too much.
This ties in nicely when investing in cheap shares. With valuations in the gutter, these businesses often come attached with a wide margin of safety. So even if an investor overestimates the true value of the businesses, there’s still a good chance of making money.
Of course, that’s never guaranteed. And just because a stock looks cheap, it doesn’t necessarily mean it’s a bargain.
Avoiding value traps
When volatility is high, as it has been in recent years, it’s easy for investors to start panic selling. This is why so many top-notch companies end up dropping off a cliff during a crash or correction, even if the underlying business isn’t significantly affected by the source of investor concerns.
While it’s tough to watch a portfolio tumble during such periods, it presents a rare buying opportunity for investors focused on the long term. However, in some instances, a sharp drop in valuation could be justified. Therefore, investors can’t simply throw their money at the most beaten-down stocks and expect to earn a good return.
Regardless of the company, it’s essential to investigate why a stock has been sold off. Temporary disruptions to operations aren’t a major concern. But a new rival product that’s caused a firm’s own solutions to become obsolete is a far more serious threat. As is a debt-heavy balance sheet squeezing profit margins, or breach of regulatory compliance.
By carefully investigating the strengths and weaknesses of each business, most value traps can be avoided. However, the risk of falling into one can never be entirely eliminated.
Therefore, diversification also plays an important role when capitalising on undervalued businesses in the stock market. Should a position later fail to live up to expectations, the strong performance of other bargains can offset the negative impact and help push investor wealth in the right direction.
