In 2022, we experienced a stock market correction. But it was a little different from the ones we’d seen in recent years.
Instead of the whole market suffering, some stocks, namely those in resource sectors, surged. Meanwhile, many stocks in sectors like housebuilding and retail tanked.
As an investor, stock market corrections can be challenging. But they also create opportunities.
Fallen stocks
Right now, hundreds of FTSE stocks are trading at discounted prices after a challenging 12 months. In this case, these discounts are only relative to their previous prices — many UK stocks are cheaper than they were last year.
If I want cheap stocks, clearly the resource sector isn’t the right place to look. In fact, this remains one of the few areas of the market that’s buoyant right now.
I’m looking at stocks in banking, retail, and other service sectors. One area to be hit hardest is housebuilding. But with interest rates unlikely to start falling until the second half of the year, I’m just keeping a close eye on the sector.
Finding discounted stocks
A stock can be trading more cheaply than it was a year ago for many reasons. And often it reflects concerns about the firm’s near-term outlook, long-term prospects, or the health of its dividends.
However, if I really want to find stocks that are meaningfully undervalued, I’ve got to do my research.
One place to start is by looking at simple metrics such as the price-to-earnings, price-to-sales, or enterprise value-to-EBITDA ratios. These metrics, along with many others, help me in deciding whether a stock is cheap or not.
Naturally, this requires me to compare stocks across the same sector.
However, these metrics are slightly limited in that they don’t give me great visibility going forward.
Instead, I need to apply more detailed mathematics. One such calculation is the Discounted Cash Flow (DCF) model. This valuation metric attempts to determine the value of an investment today, based on projections of how much money that investment will generate in the future.
The only issue is the DCF model requires me to make forecasts on the company’s earnings up to 10 years into the future. This can be tough and poor estimates will generate to misleading calculations.
Getting rich?
Can buying discounted stocks help me get rich? Well, it all depends on my investment strategy, how much money I invest, and my definition of rich.
I tend to hold out in bull markets and buy when stocks are falling. That’s my strategy and it helps me in my aim to deliver index-beating returns, or around 10% annualised growth. Perhaps I won’t become Warren Buffett-style mega-rich, but growing my wealth year on year is one way of getting richer.
It may not sound world-beating, but it’s part of a calculated strategy.
And there are very good reason for buying meaningfully discounted stocks. They can help supercharge my portfolio forward when the market recovers and even reduce the risk of losing money.
After all, investors like Buffett — the Berkshire Hathaway boss — search for undervalued stocks as part of their value investing strategy. In fact, the Oracle of Omaha looks for a substantial ‘margin of safety’, meaning the share price of a stock indicates a 30% discount versus what he believes it should be worth.
