In spite of a recent rally, many FTSE stocks are trading at discounts over 12 months. This is illustrated by the FTSE 250 which is down 12% over the year.
While this correction hasn’t been positive for most investors, it creates opportunities, especially for me as a value investor.
Discount environment
UK indices have been hauled upwards by surging resource stocks — oil and energy giant Shell is up a huge 29% over the year. But the majority of UK stocks are still trading at discounts over 12 months.
For example, stocks in the housebuilding sector are down around 35% over 12 months, on average. Housing giant Persimmon has had a whopping 43% wiped off the value of its share price. Other sectors, including banking, retail and travel have also suffered.
Some stocks are cheaper for a reason. But in this highly discounted environment, I have a better chance of finding undervalued stocks.
Value investing
Value investing is a philosophy that involves purchasing stocks at a discount versus their intrinsic value. This discount is often referred to as a security’s margin of safety.
So this bear market environment should create the ideal conditions for value investing.
Warren Buffett is among the most famous value investors in the world. The so-called ‘Oracle of Omaha’ focuses on buying meaningfully undervalued stocks, not just companies that look cheap because they’re less expensive than they were a year ago.
Value investing requires me to do research. I can look at simple metrics as the price-to-earnings, price-to-sales, or EV-to-EBITDA ratios, and compare against peers. Or I can run discounted cash flow (DCF) models.
Applying Buffett’s teachings
Buffett tells us not to follow the crowd and to be fearful when others are greedy. So I definitely need to be looking at the bear sectors.
One firm I’m buying more of is joint replacement specialist Smith & Nephew. The stock is yet to recover from the pandemic when elective surgeries took a backseat as healthcare resources were focused on Covid-19.
The stock still isn’t popular. But a DCF model with a 10-year exit suggests the firm could be undervalued by 40%. I’m also forecasting a better 2023 for the firm, as Covid becomes less problematic and the backlog of elective surgeries is tackled.
The legendary US investor also tells us to stick to what we know best. This is one reason I don’t focus on pharma stocks. That’s because I just don’t properly understand the size of certain drug markets, and interpreting trial data can be difficult.
In several respects, banking stocks can be easier to value. In recent months I’ve increased my holdings in Lloyds. The bank currently has two major forces acting on it.
Recessions normally mean bad debt and more impairment costs for banks. And the current environment clearly isn’t great. But higher interest rates are providing a huge tailwind and this will continue to push revenues up for some years.
I see Lloyds as being a net beneficiary of the current environment and a DCF model suggests its undervalued by 40%.