Today’s volatile stock market may cause many investors to avoid buying cheap stocks. They may determine that other assets with lower risks are a better option than companies that face challenging operating conditions in many cases.
However, the track record of the stock market shows that buying undervalued shares can lead to high returns over the long run. As such, now could be the right time to purchase high-quality businesses that trade at cheap prices.
Here’s how you could achieve that goal, and in doing so improve your financial prospects in the coming years.
Identifying sectors with cheap stocks
Perhaps the first step to take when seeking to find cheap stocks is to identify which sectors currently offer good value for money. Although the stock market has rebounded since the market crash, some sectors continue to contain companies with extremely low valuations. In many cases, undervalued sectors have uncertain near-term outlooks that have caused investors to demand wide margins of safety.
Clearly, some sectors may be cheap for good reason. They may be unable to fully recover from the challenges they face, and the business models of their members may prove obsolete due to changing consumer trends. However, by identifying sectors with near-term challenges and long-term recovery potential, you may be able to unearth a large number of good value stocks that can be added to your portfolio.
Just as some sectors may be undervalued for good reason, some cheap stocks may have very undesirable future prospects. Therefore, accessing annual reports may help you to understand which companies offer recovery potential, and which businesses may fail to experience a sustained rally in the coming years.
Annual reports are free to access for any investor, and contain a vast amount of information about a business. Together with recent trading updates, they allow an investor to paint an accurate picture of the strengths and weaknesses of a business that can be used to value it. A buying opportunity may exist if its stock price is currently significantly below its intrinsic value.
At the present time, it is difficult to ascertain whether cheap stocks offer good value for money on a standalone basis. Their outlooks are opaque due to a challenging economic future.
Therefore, it could be prudent to identify businesses that trade on lower valuations than their sector peers. Although no two businesses are ever identical, companies operating in the same sector and geographies are likely to face similar risks and growth opportunities. By comparing their prices, it may be possible to determine whether they offer investment appeal for the long term.
Clearly, not all cheap stocks will deliver a successful recovery. However, the track record of the stock market suggests that buying a diverse range of businesses at low prices can lead to high returns in the long run.
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*Returns as of June 30th
Motley Fool contributor Peter Stephens has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.
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