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The stock market took a hammering in 2022. The FTSE 100 was one of the few indices not to bear considerable losses over the course of the year. But that’s because the index was dragged upwards by surging resource stocks.
So with many parts of the market still suffering, I’m hunting for fallen shares to propel my portfolio forward when the market recovers. Here’s what I’m looking for.
Stocks may appear cheap if they’re trading for less than they did a year ago. But I want shares that are actually undervalued. And I think these stocks are easier to find in a bear market than a bull market.
This also requires me to do some research. Using near-term valuations such as the EV-to-EBITDA ratio or the price-to-earnings metric, and comparing among peers within a sector, I can develop a fairly good idea of relative valuation.
I can also use the discounted cash flow (DCF) model, but this requires me to make estimations about future earnings. And that can be difficult. But if done correctly, I can build a better idea of the value of my investment moving forward.
What I’m picking
Dividend stocks form the core part of my portfolio. So, more often than not, I’m looking for dividend stocks that are undervalued. Moreover, when share prices fall, dividend yields go up — assuming dividend payments remain constant.
That’s why I’ve been buying stocks such as Direct Line Group and Lloyds. The former has a sizeable 10% dividend yield, while the latter’s yield is 4.5%. Both of these yields are enhanced by the share prices that remain down on previous levels.
I’m also picking Direct Line Group because the firm appears to be trading at a discount versus its peers. A DCF model suggests that the financial services outfit is currently trading 46% below its fair value.
Discounted cash flow calculations also suggest that Lloyds is trading around 45% below its fair value. The bank’s revenues are currently being driven upwards by soaring interest rates. Despite the macroeconomic environment, near-term prospects look positive.
But I’m not ignoring growth stocks. I think the macroeconomic environment, characterised by high interest rates and slow growth, isn’t conducive to the growth of these stocks. However, there are some companies that I’m backing to outperform.
With China’s reopening, I’ve recently invested in NIO and Li Auto. The two Chinese EV firms suffered from Covid restrictions, but the reopening of the economy should be a major boost.
I prefer dividend stocks as these allow me to pursue my compound returns strategy. This is essentially the process of reinvesting my dividends year after year and earning interest on my interest.
For example, if I invested £10,000 in stocks averaging a 8%, and reinvested my dividends for 30 years, at the end of the period I’d have £81,000. That’s considerable growth, but it doesn’t include share price growth. Of course, my picks might not grow and I could even lose money. But it’s worth remembering that the FTSE 100 is four times larger today than it was 30 years ago.
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