The UK economy seems to be slowly on the mend, but there continues to be plenty of cheap shares scattered throughout the stock market. It seems not every investor has regained their confidence. But the tide does appear to be turning.
Leading indices like the FTSE 100 and FTSE 250 are up by roughly double digits since October last year. This indicates a recovery is already well underway. And it means terrific top-notch stocks that were sold off in the initial panic may soon stop being on sale.
Finding buying opportunities
There will always be good businesses caught in a panic-selling crossfire. Consequently, buying opportunities will always exist, but the trick is being able to find them.
In the currently volatile climate, such opportunities are more common than usual, thanks to investors letting their emotions rule over decision-making. That’s why, in my opinion, a good place to start searching for bargains is among the shares that have performed the worst.
A closer inspection of these losers will likely reveal sound justification for shareholders jumping ship. But every once in a while, investors might have overreacted.
It’s important to investigate why a stock has tumbled. Suppose a fundamental issue has been revealed that compromises the investment thesis? In that case, the risks probably won’t be worth the potential reward.
But if the problem, either internal or external, is only causing short-term disruption, and the company has the resources to weather the storm, then a buying opportunity may have emerged.
As famous contrarian investor Nathan Rothschild once said, “buy when there’s blood in the streets, even if the blood is your own”.
Managing risk
Investing in high-quality shares trading at a discount is a proven recipe for building wealth. However, that doesn’t mean the strategy is risk-free.
It typically takes far longer for a stock to recover than it did to crash. Don’t forget in the near term, the stock market is driven by sentiment. And looking at the state of the markets today, it could be a while before confidence returns to the masses.
In the meantime, should the economy take a turn for the worse, cheap-looking shares might get even cheaper. In theory, this sounds like a bonus since it means smart investors can now buy even more shares at an even better price. But in practice, uncertainty starts to creep in, creating doubt that the bargain might actually be a trap.
But even if an analysis is spot on at the time, a new threat might emerge that compromises a thesis before the stock has a chance to recover, turning a good investment into a bad one.
That’s why it’s critical to diversify across multiple top-notch stocks instead of just one. That way, if a mistake is made, the impact can be offset by other stronger positions within a portfolio.
