The stock market has been busy recovering from last year’s correction, and many once-cheap shares are starting to carry loftier valuations again. But that doesn’t mean bargains aren’t still around.
While periods of volatility tend to create more buying opportunities, there are always discounted valuations for investors to capitalise on. And successfully identifying these companies can provide a much greater scope for an investor’s capital growth.
Having said that, it’s easy to accidentally fall into a value trap. So how can investors avoid these pitfalls? Let’s explore.
Quality is key
The value of a business is ultimately tied to its quality. A company with a bad reputation for making shoddy products isn’t likely to last long in a competitive marketplace. But a firm that’s revered for its excellence by customers can often find itself developing both pricing power and market share.
That’s why a portfolio of high-quality enterprises is more likely to deliver better returns versus a collection of mediocre ones. There’s always an element of risk. But investing in firms with healthy financials, strong customer loyalty, and broadening target markets minimises the chance of failure while maximising the potential long-term gains for shareholders.
Price still matters
Even if an investor successfully identifies the world’s best businesses to buy, that doesn’t guarantee they’ll be a good investment. In fact, there are countless examples of top-notch stocks turning into disappointing disasters for shareholders if the wrong price is paid.
In other words, value traps aren’t solely created by badly managed enterprises but by the best ones as well.
Determining a fair price to pay when investing in stocks is a complex process that even professionals struggle with. Fortunately, in 2023, things are a bit easier, with volatility still present in the financial markets.
When investors are still battling with uncertainty, cheap shares are more common and easier to identify using relative valuation metrics such as the P/E ratio.
By comparing the P/E ratio to its historical or industry average, investors can get a rough idea of whether a stock is trading above or below its usual relative price point. However, once again, quality is key. If a company looks like a bargain, investors need to figure out why.
Suppose a company is currently facing supply chain disruptions that cause customer orders to be delayed in the short term? In that case, investigating whether its competitors have the same problem can help illuminate the situation.
And suppose its rivals are still completing orders on time. The firm may struggle to retain customers, potentially permanently losing market share. On the other hand, if it’s an industry-wide problem, then investor pessimism may be unwarranted, creating a buying opportunity for the long term.
