Finding the best undervalued stocks to buy and hold is an investment strategy that’s proven immensely lucrative over the long term. In fact, it’s exactly how billionaire investors like Warren Buffett built their fortunes.
The objective is to identify high-quality businesses whose current market-cap underappreciates the enterprise’s existing or future potential value. Usually, identifying such opportunities is quite challenging. But with emotions running high courtesy of the 2022 stock market correction, bargains seem to be all around.
Finding the best stocks
Regardless of what state the economy or stock market is in, there are always sectors that lose favour with investors. And this is where undervalued shares typically reside. During a crash or correction, the list of unloved industries gets pretty long, making it far easier to find buying opportunities.
The challenge is figuring out which companies within these sectors are merely facing short-term disruptions as opposed to being fundamentally compromised. And often, a good place to start is the balance sheet.
A slowdown in consumer spending can put pressure on the cash flows of even the largest companies in the world. While frustrating, that’s not necessarily a problem if these businesses have the financial resources to weather the storm. That’s why seeing a firm with a sizable war chest of cash on the books is a promising sign.
Something else to consider is the level of debt. An over-leveraged business may find itself in hot water during an economic slowdown.
With cash flow becoming tighter, fewer funds are available to cover the interest expenses on outstanding loans. Even if there is sufficient operating profit to service debts, it still pressures profit margins, reducing internal reinvestment, thus creating opportunities for competitors to steal market share.
Obviously, there is much more to consider beyond the financial health of a business when looking for the best stocks to buy in 2023. But this simple health check is a quick way of eliminating bad companies from consideration.
Knowing the risks
2023 is off to a good start. The FTSE 100 is now ahead of pre-pandemic levels, while the FTSE 250 is continuing its upward streak that started in October last year. As such, it looks like the storm may have passed with the stock market recovery well underway.
In reality, it’s impossible to know for sure. And there’s the risk that we may be in the calm eye of a hurricane about plunge back into chaos. After all, there remains a lot of uncertainty within the British economy, with the Bank of England issuing new warnings of prolonged inflation.
As such, even if investors find the best undervalued stocks to buy now, there’s the risk of valuations dropping even further in the coming months. Don’t forget, in the short-term, share prices are driven by mood and momentum, not fundamentals.
This is the risk of investing in a volatile market. And while trading tactics like pound-cost averaging can mitigate some of the impacts, it’s impossible to avoid it altogether. But for shrewd investors, taking this risk can potentially unlock impressive market-beating returns.
