After almost two years of volatility, UK shares have finally started moving in the right direction. Pairing falling inflation with a halt in interest rate hikes, the stock market is seemingly bouncing back.
However, even with some trends now moving back in the right direction, there are plenty of British businesses still trading at discounted valuations. In some instances, these discounts are justified. But in others, terrific buying opportunities for prudent investors may exist. And capitalising on them at the start of 2024 could lead to lucrative returns in the coming years or even months.
Volatility creates opportunity
While the FTSE 100 has proven to be remarkably resilient throughout this stock market correction, the same can’t be said for the FTSE 250. The UK’s flagship growth index dropped by almost 30% between January 2022 and October 2023. And even after including the index’s recent rally, it’s still down by nearly 20% over the last two years.
This isn’t exactly surprising. The FTSE 250 contains far more smaller businesses. During economic turbulence, these are the firms that are often hit the hardest. But does that mean they’re all doomed? Certainly not.
There are plenty of sold-off stocks in this index that have suffered through stock market crashes and corrections before. In many circumstances, they ended up making a full recovery before moving on to reaching new record highs. And I doubt that this time around will be any different.
Of course, this doesn’t guarantee that every beaten-down stock is a bargain. Not all businesses will survive the storm. And we’ve already seen a few venture into the realm of bankruptcy, with several others seemingly heading in that direction.
Separating winners from losers
Picking stocks during a volatile environment can be a bit hectic. Mainly because the short-term feedback can be wildly misleading. When tensions are high, it’s not unusual for a terrific company to plummet into the gutter or even an appalling enterprise to be sent flying sky-high.
‘Pound cost averaging’ (investing small amounts regularly) can offset the impact of this volatility as well as potentially lead to higher long-term gains. However, this strategy can just as easily destroy wealth if investors aren’t able to identify which companies have the capacity to bounce back from the ongoing economic turbulence.
Today, one of the primary threats is interest rates. Firms that have grown overly reliant on debt over the last decade may find themselves in hot water as previously affordable loans become unaffordable.
However, even the companies that have restructured their loan obligations may still struggle in the coming years. The cost of capital is now the highest it’s been since before the 2008 financial crisis. And that means relying on external financing to pursue new growth opportunities may no longer be viable for many businesses, even the debt-free ones.
This is why investors have begun to place a lot of emphasis on earnings and profitability. But that’s not what I’m interested in. There are plenty of profitable enterprises going nowhere on the London Stock Exchange. Instead, I’m looking at free cash flow. After all, businesses that can consistently generate more cash than they need from operations are less likely to rely on debt to achieve their goals.
