Now is a great time to invest a lump sum in the stock market. After the recent stock market crash, there are many cheap shares for investors to choose from.
However, it is becoming clear that the economic disruption from the coronavirus crisis may last for some time. Therefore, investors need to be careful when picking undervalued stocks.
Many cheap shares could see a significant deterioration in their trading performance over the next few months. That could lead to losses for investors in these businesses.
On the other hand, some cheap shares have bright prospects and strong balance sheets. These companies could produce attractive capital and income returns for investors over the long run.
Finding cheap shares
If you are looking for cheap shares, the best place to start could be the FTSE 100.
These blue-chip businesses are much more likely to survive the coronavirus crisis because policymakers have acted quickly to provide financing. Small businesses have not been so lucky.
Many smaller companies are struggling to raise additional financing to weather the storm. Some even entered the crisis with a lot of debt, which could limit their ability to survive if profits drop precipitously.
Even though it has recently surged back above 6,000, the FTSE 100 is still full of cheap shares. Many companies are only just starting to get to grips with the new normal, which could present an attractive opportunity for long-term investors.
There are plenty of other attractive cheap shares outside the FTSE 100 as well. The best companies are those that have a definite competitive advantage over peers. This could be anything from a unique product to big economies of scale or sticky client base.
The best way to find these companies to look for businesses with large profit margins or a high return on equity (ROE). These metrics can signal that a business is earning a lot more profit than the rest of the sector. It usually has a competitive advantage that’s helping it meet this objective.
As mentioned above, it could be some time before the world economy returns to normal. As such, if you are looking to invest a lump sum in cheap shares today, the best way to limit risk is to buy a diversified basket of these stocks.
Even if you stick with the market’s top blue-chips, considering the current situation, there’s no telling if these stocks will still be around in a year.
By diversifying, you can protect yourself from the worst-case scenario as even if one or two businesses in the portfolio fail, you will still have money left to stage a comeback.
Overall, while the outlook for the global economy might be uncertain, now could be an excellent time for long-term investors to snap up high-quality cheap shares at a discount.
The potential for long-term profits could far outweigh the near-term risk of following such a strategy.
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Rupert Hargreaves has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.