I’m always on the lookout for cheap shares to supercharge my portfolio. That’s because buying when shares dip gives me the chance to boost my gains when the market recovers. It can also reduce my risk of losses. However, picking the right stocks isn’t easy.
Correction creates opportunity
The FTSE 100 has gained since Rishi Sunak took office, pushing back towards 7,500. But the truth is that many UK stocks have suffered in 2022 and now trade at considerable discounts, while the FTSE 100 has been dragged upwards by surging resource stocks.
Stocks in sectors like banking, retail and housebuilding certainly look cheap in that they’re trading considerably lower than they were a year ago. Several housebuilder stocks are down 50%! But it’s worth remembering that stocks are often cheap for a reason.
The challenge is finding stocks that are meaningfully undervalued.
Finding value
Many great investors have their own formula for assessing whether a stock is meaningfully undervalued. For example, we know Warren Buffett searches for a margin of safety around 30%, meaning the share price of a stock indicates a 30% discounted versus what he believes it should be worth.
There are several ways I can try to work out whether a stock is meaningfully undervalued or not. I can look at simple metrics such as the price-to-earnings, price-to-sales, or EV-to-EBITDA ratios and compared against peers.
Or I can use more complex methods such as the discounted cash flow model. This analysis attempts to determine the value of an investment today, based on projections of how much money that investment will generate in the future.
My picks
Discounted cash flow analysis suggests that Lloyds could be undervalued by as much as 63%. The model indicates that the stock could be worth as much as £1.23, way above the current 45p.
The stock, like other banking stocks, often reflects the health of the economy — and, right now, economic forecasts aren’t positive.
However, there’s currently a tailwind in the form of higher interest rates. The UK-focused bank is even earning more interest on the money it leaves with the Bank of England — around £200m in revenue for each 25-point basis hike.
Largely due to the same reasons, I’m also picking Barclays. The giant banking group is benefitting from higher rates, but to a lesser extent than Lloyds. The group has less interest rate sensitivity as less of its income is derived from lending — Barclays has an investment arm that has been particularly successful in the recent climate.
I’m also picking pharmaceutical/biotech giant GSK. Discounted cash flow modelling indicates a fair share price of 1,863p, around 23% up from the current position. This comes despite a recent surge following the Zantac court case win. And with an ever-ageing global population, I see plenty of growth opportunities in healthcare.
I already own shares in these three stocks, but I’m looking to buy more in the New Year.
