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The FTSE 100 might look like it’s doing pretty well. It’s up 3% over 12 months.
But that’s not the whole story. The index has been hauled upwards by surging resource stocks, while many of the UK’s largest firms have suffered in the low growth and high inflation environment. The FTSE 250 is more illustrative of the challenges UK firms have faced — it’s down 14% over the year.
Clearly, many investors have suffered in this environment. But a bear market also creates opportunities.
What are cheap shares?
So, what are cheap shares? Well, it’s definitely not just stocks that are trading with lower share prices than a year ago. Some stocks are cheap for a reason.
It’s about looking at fundamentals, metrics, and models, and comparing stocks against their peers.
Using near-term valuations such as the EV-to-EBITDA ratio or the price-to-earnings metric, I can develop a good idea of relative valuation. But I need to compare figures among peers in the same sectors.
The discounted cash flow (DCF) model is another method. But this requires me to make estimations about future earnings. And that can be difficult.
Collectively, using these methods, I can build a better idea of the value of my investment moving forward.
Blue-chip purchases
I’m always on the lookout for quality stocks to add to my portfolio. That’s something Warren Buffett teaches us when he says he’d rather pay a fair price for a great company than a great price for a fair company.
Lloyds is one such company that I’ve recently topped up on. UK banking stocks have been depressed for some time amid concerns about Brexit, Covid and inflation-related bad debt. As such, DCF models suggest that the bank could be undervalued by as much as 60%.
The lender is highly dependent on mortgage income. And currently, that appears to be positive. Interest rates are soaring and the net interest margin is pushing towards 3%.
Another stock benefitting from higher interest rates is Barclays. Some analysts predict that higher rates could lead to an interest rate tailwind of £5bn in incremental revenue by 2025.
I’ve recently bought more of this stock, as, for one, it’s the cheapest UK financial institution, trading with a price-to-earnings ratio of 4.7. This reflects some fines and impairment charges incurred over the past year, but I think the future is positive for this bank.
My pick for growth
Scottish Mortgage shares have tanked over the past 18 months, but that reflects the value of the shares it holds. The investment trust owns a good spread — aiming to stay within 50-100 holdings — and has an excellent record of picking the next big winner.
After the correction on growth stocks last year, I’m finding this part of the market a lot more attractive. And given the firm’s record, I’m making an exception to my do-it-yourself mantra. I now hold Scottish Mortgage shares in my pension and ISA.
