How to spot an opportunity in a volatile market

Warren Buffett famously explained why a bear market can be a good thing for investors by likening shares to hamburgers.

“To refer to a personal taste of mine, I’m going to buy hamburgers the rest of my life. When hamburgers go down in price, we sing the ‘Hallelujah Chorus’ in the Buffett household. When hamburgers go up in price, we weep. For most people, it’s the same with everything in life they will be buying – except stocks. When stocks go down and you can get more for your money, people don’t like them anymore.”

We tend to agree with this sentiment – for long-term investors, a downturn in the markets can offer heaps of opportunity. However, a falling price doesn’t necessarily signal a bargain.

If your favourite food’s on offer at the supermarket, the first thing you might do is check the expiry date to make sure it’s still worth buying. Sometimes there’s a good reason for the discount. The same’s true for the stock market. And just because a stock has halved, doesn’t mean it can’t do so again or worse.

While there’s no hard and fast way to determine whether a share is a deal or a dud, there are some ways to assess whether a company’s worth considering.

Investing in individual companies isn’t right for everyone – it’s higher risk as your investment is dependent on the fate of that company. If a company fails, you risk losing your whole investment. If you cannot afford to lose your investment, investing in a single company might not be for you. You should make sure you understand the companies you’re investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

This article isn’t personal advice, if you’re not sure if an investment is right for you, seek advice. All investments can fall as well as rise in value, so you could get back less than you invest.

What’s a ‘bargain’?

It’s long been said that price is what you pay and value’s what you get. This mindset is important when it comes to finding stocks that could make a turnaround. Share prices fall for many reasons and determining exactly what’s going on should be the first step in your assessment.

FTSE 350 price-to-earnings ratio

Past performance isn’t a guide to the future. Source: Refinitiv, 10/10/2022.

The FTSE 350’s average price-to-earnings (PE) ratio has been relatively flat over the past 20 years, though volatility has increased somewhat more recently. This suggests that longer term, the index has tended to return to its baseline. It also supports the idea that a market downturn has the potential to be an opportunity for long-term investors.

We often use PE ratios to work out whether a stock is highly or lowly valued compared to its historical average. It’s a good touch-point to give you an idea of what investors are willing to pay for each pound’s worth of profits. Remember though, the past isn’t a guide to the future.

If a share price has fallen but future profits appear to remain intact, the PE will move lower. That might be because investors have less confidence in those profit estimates. But it could also relate to sector or market-wide concerns that this particular company is well-placed to weather. In the latter case, you could have a bargain on your hands.

Finding a diamond in the rough

We’re marching into a particularly challenging period. Persistently high inflation, coupled with a very likely recession, means it’s going to get a lot harder to sell things. We’ve already started to see some profit warnings filter through, but there are probably more on the way as we head into another earnings season.

That means now, more than ever, it’s important to find good quality companies that can hopefully weather the storm. Gone are the days of cheap borrowing and unfettered demand. As that reality sinks in, we could see an element of throwing the baby out with the bathwater as investors flee hard-hit sectors. This could present an opportunity to pick up quality names trading well below their historical average.

Balance sheet signals strength

A good place to start looking for these hidden gems is the balance sheet. As borrowing becomes more expensive and profits narrow, a strong balance sheet can be a life-raft.

Not only does it allow for some breathing room to wait out the storm, but a strong balance sheet can give a company the ability to chase market share or buy out struggling competitors. In other words, investors aren’t the only ones looking for bargains when a downturn hits.

In the years leading up to the 2008 financial crisis, the average acquisition cost almost 11 times cash profits (EBITDA). That fell sharply to 6.5 times during the crisis. For those with enough cash, downturns can offer a powerful opportunity to grow at a low cost.

So, what does a strong balance sheet look like?

That can vary from sector to sector, but a good place to start is net debt. Net debt offsets a company’s cash reserves against its debt obligations. It tells you what debt would remain if it were to use all of its cash to pay it off today. On its own, the figure tells you very little, though. Instead, it’s useful to compare it over the past few years. A net debt figure that’s increasing can be a red flag.

Debt isn’t necessarily a bad thing, especially over the past few years when the cost to pay it off has been low. Now that interest rates are on the rise, lots of companies will likely look to pay down their debt piles, especially those with inflation-linked interest rates. But a company that’s highly leveraged will struggle to do that. That’s why it’s a good idea to compare net debt to cash profits. As a general rule, net debt that’s two times cash profits or higher can be considered wading into risky territory.

How resilient are margins?

When inflation is high and demand is starting to taper, margins can come under fire. It’s more expensive to make and sell your products, but passing those costs on to customers can send them running to lower-priced competitors. As companies walk this tightrope between protecting demand and covering their costs, it’s helpful to have a buffer.

There are a few ways to evaluate how vulnerable a company’s margins are. Of course, the wider they are, the better. If margins are already razor thin, the only lever management has to pull is cost-cutting. This could come at the expense of future growth.

But it’s also worth considering where they’re placed within their industry and how that might play out. Premium brands tend to command higher price tags even when the economy is struggling. This is because customers are willing to pay more for a name they trust. This tends to offer a bit more shelter in times of turbulence.

The same can be said for necessities. Industries like healthcare and defence tend to see a relatively constant level of demand. This means they’re more likely to be able to pass costs on to customers, therefore protecting their margins.

Switching costs are another factor to watch as well. If it’s relatively easy for clients to swap from one company to another, margins are exposed to undercutting by competitors. This is a challenge in the telecom space, where there’s very little differentiation between companies. So, although internet connections are a necessity in today’s world, there’s nothing to stop you from shopping around for a cheaper alternative when your contract expires.

Revenue visibility

It’s impossible to predict the future with 100% accuracy, but the setup at some companies means they can get close. Membership-based companies with steady renewal rates and those that make deals decades into the future have a good degree of revenue visibility. That makes executing on a strategy much easier to do.

That’s not to say these companies are immune. Rising costs will still squeeze margins and some level of demand erosion is still a risk. Plus, subscription-based companies are always at risk of a mass exodus when household budgets are thin. Predictable revenue is a powerful strength when things take a turn for the worse, but it’s important to understand predictable isn’t the same as set-in-stone.

Companies with solid order books and a long history of loyal membership renewals are better placed than up-and-comers in crowded industries.

Look for companies with a proven track record of subscription renewals, like those that offer essential services to businesses. It could also be worth considering aerospace and defence companies, whose multi-billion-pound order books tend to be linked to more reliable customers.

The bottom line for investors

It’s more important than ever to understand the companies you’re buying. Market downturns can offer opportunity, but it’s impossible to time the market with any certainty – it could get much worse before it gets better. For those willing to stomach some volatility, now could be a great time to get some quality companies on your watchlist.

All of the information above can be found within a company’s financial statements, but the Share Research team will do a lot of the legwork for you. The team offers in-depth research on over 100 of the most popular stocks.

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