Cheap shares continue to be prevalent in the current market landscape. The British economy still has a long way to go before inflation and interest rates fall back to preferred levels. But both the internal and external outlook for the UK is improving. And with earnings season ramping up, a lot of businesses are posting encouraging results.
A stock market recovery will eventually emerge. While historical performance isn’t always the most reliable for forecasting results, a perfect track record of recovery from even the direst financial disasters is hard to argue with. And while it’s impossible to know when the markets will bounce back from this ongoing correction, steadily improving earnings reports are an early indicator that it might be near. Perhaps it’s already started.
Therefore, buying top-notch cheap shares today could be an exceptionally lucrative move in the coming years.
Finding bargains and avoiding duds
It’s important to understand that cheap shares aren’t just the stocks that trade at a low price tag. It’s entirely possible for a business trading at £5 a share to be far cheaper than another at just 50p. That’s because a stock price alone is meaningless in the hunt for buying opportunities.
Instead, market capitalisations need to be compared against a firm’s underlying intrinsic value. As Warren Buffett puts it, “price is what you pay, value is what you get”.
Unfortunately, this is where things get complicated. Determining the intrinsic value of a business is a long and arduous process that requires a detailed understanding of operations, growth avenues, competition, risks, and countless other factors. And subsequently, building a robust discounted cash flow model can take a long time.
However, by taking a relative approach, estimating value requires far less time. The price-to-earnings (P/E) ratio is one of the most commonly used metrics for relative valuation. By observing the value of this ratio over time and comparing it to an industry average, it’s possible to identify potential buying opportunities.
In general, the smaller the value, the “cheaper” the shares. But in some cases, a low P/E ratio can be an early warning sign that something is fundamentally wrong with the business. Therefore, investors still need to perform critical due diligence before jumping on what seem to be terrific buying opportunities.
Patience is critical
As any value investor knows, this style of investing requires tremendous patience. In the long run, a stock price will ultimately move based on the performance and quality of the underlying business. But in the near term, prices are determined by mood and momentum.
Subsequently, even if an investor buys discounted shares in the world’s greatest enterprise, they might be waiting a while before their return materialises. In fact, an overly pessimistic stock market, like the one we currently have, may drag these shares down even further before realising it’s a terrific investment.
This process of realisation can take months or even years. And during that time, doubt may start to creep in. After all, there’s no way of knowing for certain if an investment thesis is accurate until after a share price has jumped. And if a position is seemingly going nowhere, investors might start to second-guess their analysis.
Selling too early can be just as disastrous as selling too late. But by investigating the risks as well as the potential rewards and keeping a diversified portfolio, patience can ultimately lead to phenomenal long-term gains.
