The stock market recovery has pushed many UK shares to significantly higher prices. Even though the FTSE 100 and FTSE 250 are trading below their pre-coronavirus levels, some of their members now trade at prices that may overvalue their prospects.
Buying overvalued stocks can mean there’s an unfavourable risk/reward opportunity, since their prospects may already have been factored in by investors. By contrast, today’s cheaper shares could lead to higher returns in a likely long-term stock market recovery.
Avoiding overvalued UK shares
Investing money in UK shares has been a successful move for many investors in the past. After all, the stock market has generally produced annualised total returns in the high-single digits over recent decades.
However, buying companies for more than they are worth may be a risky move. After all, buying any asset at a price that already reflects its future prospects could mean there’s very limited scope for further capital growth. And, with the prospects for the economy remaining very uncertain at the present time, it may be worth seeking a margin of safety so a company’s valuation has some of its risks priced in.
Buying cheap stocks ahead of a market recovery
Of course, avoiding overvalued UK shares doesn’t mean that buying cheap shares is always the right move. Some cheap stocks are priced at low levels because they have significant problems. Such as weak financial positions or very tough operating conditions.
Therefore, it’s crucial to check the quality of a business before buying to ensure it’s undervalued based on its quality and market position versus peers.
However, some companies appear to have missed out on the recent stock market rally and may continue to offer good value for money. In some cases, they may have sound financial positions and solid strategies through which to enjoy improving financial performances. Where they trade at prices that undervalue their prospects, they could offer less risk and higher reward potential versus their higher-priced peers.
They may be able to capitalise on a long-term stock market recovery, as well as the potential for improving operating conditions as the world economy comes back from today’s difficulties. As such, they could offer a more favourable risk/reward buying opportunity compared to higher-priced stocks.
The potential for a stock market rally
A stock market recovery from its current level is not guaranteed. Even if it does take place, some UK shares may fail to fully bounce back from the challenges caused by coronavirus.
Therefore, it’s crucial to purchase a wide range of businesses at fair prices. In doing so, an investor can reduce their exposure to a small number of companies. That means they’re less reliant on the performance of a limited range of stocks.
Over time, this may allow them to capitalise on a broader range of growth opportunities, while experiencing less risk. This may lead to a more resilient and stronger performance from their portfolio in the coming years.