Dirt-cheap shares could be among the biggest beneficiaries of a long-term stock market recovery. Their prices could currently include wide margins of safety that provide significant scope for capital growth in a rising stock market.
A strategy of buying such companies has generally been very successful in the past. As such, with many cheap stocks including companies that have dominant market positions and sound finances, now could be the right time to capitalise on their low prices.
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High potential returns from dirt-cheap shares
Buying any asset at a lower price is usually a better idea than buying it at a higher price. It means there is greater potential to generate capital returns, since investors may not have priced in its long-term growth prospects. This logic has generally been profitable when applied to dirt-cheap shares, with them providing scope to outperform the wider stock market during a recovery.
For example, previous crises such as the dot com bubble and the global financial crisis have prompted some companies to experience severe declines in their share prices. Although in some cases they have lasted for many months, or even years, a stock market recovery has always taken hold. This has often meant that those investors who buy undervalued stocks have benefitted the most from a subsequent stock market rally.
A focus on quality companies
At the present time, many dirt-cheap shares face tough operating conditions. This may mean that they experience a decline in sales or profitability in the current year. However, such conditions are likely to be only temporary in nature. Often, they are being caused by disruption to specific industries as lockdown measures have been used to prevent the spread of coronavirus. As they are gradually lifted, improving sales and profit performance could be ahead.
Moreover, many cheap stocks are high-quality businesses that are likely to survive a period of disruption to their operations. For example, they may have low debt levels, sound strategies to adapt to a changing operating environment, as well as a track record of defensive characteristics in periods of weak economic performance. Such companies could be grossly undervalued, since investors may be overly focused on their short-term prospects instead of their long-term profit capabilities.
Reducing risks in a portfolio
Clearly, not all dirt-cheap shares will recover from the current economic challenges facing many sectors. Therefore, it is important to focus on fundamentals such as debt levels and other financial metrics to ascertain their financial strength. Similarly assessing their market position versus rivals, as well as industry growth trends, may help an investor to identify the best cheap stocks to buy.
Over time, they could be strong performers in a stock market recovery. They may be able to offer higher returns than are possible from the wider stock market in the coming years.
