The FTSE 100 has moved up 11% since October. But over the past year, the index has gained less than 2%. Right now, I think even among blue-chip UK companies there are some cheap shares on offer.
I have been taking advantage of that to build my portfolio. Valuations could remain attractive for years, but nobody knows if they will. Maybe the recent stock market rally will keep going, pushing up prices. So I am making hay while the spring sun shines and valuations are attractive.
Here is the approach I am taking.
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Cheap but good
Shares can sell at cheap prices for a few different reasons.
Perhaps their future prospects look less attractive than their past ones. It may be that investors are not fully factoring in growth prospects or other factors that could help a company boost its profitability.
It can also be that investors are simply mistaken. They may be valuing a company far below what it is really worth. Over time, such price discrepancies can disappear as a company’s performance makes the City re-evaluate it.
But when such bargains present themselves, I would consider adding them to my portfolio.
Note what I am not doing – buying shares in poor companies just because they sell for a low price. Instead, I am looking to buy into strong businesses when their valuations are out of step with their prospects.
Valuing future prospects
To assess what a company might be worth, I try to get a sense of what its profits, cash flow and balance sheet are likely to be.
Past performance can be a useful starting point for digging into this, but it is important to think about what might change a company’s future performance. There could be things that make it worse, like fresh competition, shifting customer tastes, or new rules affecting its business.
But there could also be things that change it for the better and mean that today’s cheap shares are a bargain, for now. For example, a company may be about to unveil a big new client win or stand to benefit from a shifting marketplace.
Yesterday’s huge surge in the Petrofac share price in reaction to a single deal agreement is an example. Spotting a possible inflection point in a company’s likely fortunes can be profitable as an investor.
Often, any future valuation involves a lot of uncertainty. Where there is too much for me to consider, I will not bother looking further into the shares.
Moving to action
But if I find cheap shares where I feel strongly that future prospects seem outstanding, even allowing for some uncertainty, then I will consider adding them to my portfolio.
One example from the past several months is ITV. The success of its digital platform remains to be proven. A changing media landscape poses a serious long-term threat to advertising revenues in the firm’s traditional television heartland.
But with unique assets, strong cash generation, a growing third party production business and an attractive valuation, I see ITV as a cheap share. I have been adding it to my portfolio.
