One of the best things – in fact, probably the only good thing – about a stock market crash is that it always throws up opportunities to buy cheap shares.
A stock market crash is the parent of cheap shares
The reason why a stock market crash can be the friend of investors is that it gives birth to cheap shares. When investors become more fearful than greedy, they rush for the exits by selling good shares alongside the bad.
As a result, dramatic market crashes cause major dislocations in the value of otherwise great firms. In these situations, shares in good businesses are driven down in price. This turns them into cheap shares tossed into the market’s bargain bin.
Two ways to find cheap shares
I use two simple ways to identify cheap shares. The first is when the market undervalues the company’s future earnings. Over time, this stream of earnings will turn into dividends, share buybacks and other goodies for shareholders. I identify cheap shares in this category by their low price-to-earnings ratios (P/E) and high dividend yields.
The second way I spot cheap shares is to pick out companies whose prices are very depressed, but should bounce back in future. In my view, the economic havoc caused by Covid-19 has pushed a large number of FTSE 100 shares into this group.
For me, this FTSE 100 share price is too low
Thanks to the 2020 stock market crash, there’s a decent haul of FTSE 100 ‘fallen angels’ among which to find cheap shares to buy today. Take, for example, ‘Big Four’ UK bank Barclays (LSE: BARC), whose share price has been badly affected by coronavirus fallout.
There’s one big problem with figuring out whether Barclays is among the ‘cheap’ shares today. Namely, that its 2020 earnings are likely to be wiped out (largely or completely) by loan-loss provisions. This means we can’t assign a P/E to Barclays shares. What’s more, back in the spring, the bank regulator ordered UK banks to suspend their dividends. Thus, Barclays also doesn’t pay any dividends at present.
However, I believe Barclays falls into my second category of cheap shares. That’s because its share price is very depressed right now, but should recover as Covid-19 cases fall and the economy strengthens. Yet today, the market value of Barclays has plunged to a mere £17.7bn.
On Wednesday, Barclays shares closed at 101.54p. That’s a healthy 39% above their crushing low of 73.04p set on 19 March, during the worst of the stock market crash. Yet they have also crashed 47.4% from their 52-week high of almost 193p that they hit on 16 December last year.
To sum up, though Barclays shares have climbed almost two-fifths above their March low, I think they have much further to rise. After all, they trade at only slightly more than half of their value 10 months ago. For me, Barclays shares are indeed in the class of cheap shares. That’s why I’d buy them today – preferably inside a tax-free Stocks and Shares ISA – to build a passive income to help me retire rich and early!