Markets don’t always work as efficiently as economists would have you believe. This means that at times of euphoria, some stocks can form price bubbles and become overvalued. At others, the share prices of strong companies can be suppressed.
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Spotting undervalued UK stocks is a great way to optimise investment returns. It can require some upfront research. There might also be a need for a degree of patience being shown. However, the rewards can be life changing.
If you’re willing to invest time in identifying an anomaly that is currently causing a stock to be undervalued and are willing to wait for it to work its way through the system, then you could make the kind of returns that the stock markets are famous for.
Table of contents
- What Are Undervalued Stocks?
- Best Undervalued UK Stocks to Buy Now
- Ceres Power Holdings Plc (LSE: CWR)
- Imperial Brands Plc (LSE: IMB)
- Standard Chartered Plc (LSE: STAN)
- Berkeley Group Holdings Plc (LSE: BKG)
- BAE Systems Plc (LSE: BAE)
- Why Invest in Undervalued Shares?
- What to Know Before Investing in Undervalued Stocks
- HOW TO START TRADING STOCKS ONLINE
What Are Undervalued Stocks?
Any calculation of a stock’s value involves combining hard data with a degree of subjective input. That’s why even top analysts at big banks who value stocks for a living can come up with different views on whether a stock is a buy or a sell.
The data-led element of the approach largely considers earnings. Most classic valuation models start by considering a firm’s current earnings, as reported in the financial statement released to the investors every quarter.
This can be used to calculate the P/E ratio, which compares a company’s current share price to its current earnings. The FTSE All-Share Index P/E ratio reached an all-time high of 34.210 in September 2016 and a record low of 7.410 in March 2009.
Stock investors and analysts are as concerned about the growth prospects of a company as they are about how it is performing currently. If they take a share position, they will get a share of future profits. This means that if a firm is considered to be able to expand market share, reduce its cost base, or come up with a new innovative product, then it should be reflected in the price now.
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If the market consensus is that a high-profile firm will outperform in the future, then it will likely have a higher-than-average P/E ratio as investors buy into the stock in expectation. The P/E ratio of EV manufacturer Tesla Inc (TSLA), for example, currently stands above the 50 mark, but has been as eye-wateringly high as 1,396.
Undervalued stocks may have a P/E ratio below the average, but that isn’t a requirement. It is more a case of investors taking a view on whether the share price now accurately reflects the future earnings potential of the firm.
This brings in the subjective element of the process. Factoring in hard-to-predict variables and taking a view on the risk-reward associated with them involves investors drawing their own conclusions. If you’re using P/E ratio methods, how do you value:
- A start-up firm that has growth potential but has not yet made a profit.
- A firm involved in a high-stakes court case that could go either way.
- A pharma company with a new wonder drug in the pipeline that could make or break it.
- Firms that saw their revenues battered by COVID-19 but ‘expect’ to return to previous levels.
Best Undervalued UK Stocks to Buy Now
Certain stocks, even big household names, can go through stages where their share price appears undervalued. The reasons for this can be many and varied but centre on new information about a stock not being correctly factored in by investors. Smaller stocks can often be undervalued because there just isn’t that much information about them.
This article will outline some methods used by the pros to make returns from UK shares that are being mispriced by the market. If you’re looking to allocate some capital to buy-and-hold strategies to generate long-term gains, then all of the below companies have a great claim to be included in your portfolio.
Ceres Power Holdings Plc (LSE: CWR)
Ceres Power Holdings is in the interesting position of receiving positive press coverage but seeing its share price slump. The pullback could be treated as an opportunity for long-term investors to buy the dip.
The hydrogen fuel-cell manufacturer and green energy service provider is yet to turn profitable but has the potential to snap up market share in a growth sector. The company’s revenue growth is impressive, although it declined year-on-year in 2022, coming in at £22.1 million compared to revenue of £30.78m in 2021. Profit margins are also improving, with the firm boasting a gross margin of 59%.
It could be a slow burn. The firm isn’t forecasting a net profit until 2027, but that is partly down to its commitment to invest all of its spare capital in a pipeline of green energy solutions. Given the potential of the hydrogen fuel sector, this could be a decision that pays off handsomely.
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The challenging balance sheet metrics have impacted CWR’s share price, but there is an argument that the stock was oversold during the 2022 crash in growth stocks.
Imperial Brands Plc (LSE: IMB)
UK-headquartered Imperial Brands manufactures, imports, markets and sells tobacco and tobacco-related products in Europe, the Americas, Africa, Asia and Australasia. Founded in 1901, it has grown an extensive global client base.
Imperial Brands’ position as an undervalued stock stems from it falling out of favour with ethical investment protocols. This market is steadily growing, and retail and institutional investors are as a result shunning the tobacco sector.
This leaves room for investors to snap up shares in a company that has an established and well-run business model and an annual dividend yield of 7.39%. Those metrics look even more impressive when the company’s status as a recession-proof stock is factored in.
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There aren’t any catalysts that are likely to make smoking more popular again. There aren’t any innovative products lined up for release. Instead, Imperial Brands is a company that just does what it is good at, and with a lot of bad news already priced in, it’s one of the best undervalued UK stocks to buy now.
Standard Chartered Plc (LSE: STAN)
London-listed Standard Chartered can be considered an undervalued stock for a variety of reasons. Its membership of the banking sector means that it is in a good position to benefit from global interest rates rising. The exposure that the firm has to growth markets in Asia could also act as a catalyst for share price growth.
The firm provides banking products and services primarily in Asia, Africa, Europe, the Americas, and the Middle East and has a retail, commercial and corporate client base.
Standard Chartered’s balance sheet can be expected to improve as base interest rates rise. This allows banks to increase the spread between the bid and offer rates applied to savers and borrowers.
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Standard Chartered may be listed on the LSE and headquartered in London, but the real opportunities for growth stem from its connections with Far East economies and its well-established global network of offices.
The firm’s site states its commitment to exploit “Trade corridors of the future” that “will cut across continents.”
Berkeley Group Holdings Plc (LSE: BKG)
Berkeley Group Holdings Plc was particularly exposed to the headwinds faced by the financial markets in 2022. It’s a relatively small-cap stock ($4.25bn), which operates in the construction industry, and has a track record of being a high-beta stock.
Having traded as high as £55.05 in 2020, BKG stock then slumped to trade as low as £32.88 in 2022. While it has gained since then, the current level still provides a buy signal for anyone looking to pick up an undervalued UK stock that has a track record of successfully navigating such peaks and troughs.
The UK market that Berkeley operates in has a chronic long-term shortage of housing stock. There remain many obstacles to developers hoping to build on greenfield sites, which makes the urban and brownfield sites that Berkeley specialises in developing a more feasible option.
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At current share price levels, BKG is a good value stock with great prospects for future share price growth as the UK’s planning controls become less stringent.
BAE Systems Plc (LSE: BAE)
Shares in multinational arms, security and aerospace company BAE Systems had a relatively good 2022, and have continued to climb this year, but still have a claim to being undervalued. Like the stocks of other firms in the sector, BAE shares have been popular among investors looking to hedge against increased global geopolitical risk.
The Russia-Ukraine conflict and the tension between China and Taiwan mean that it is unlikely that military budgets will be cut in the near future. Even without political tension fully feeding through to the share price, the firm has a strong P/E ratio. However, there is considerable potential for it to improve.
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Due to the nature of the sector, many orders are not yet showing on BAE’s balance sheet. In its Q4 2022 investor statement, the company stated that orders to replace weaponry used in the various conflicts around the world were still being processed, rather than expedited.
This means that the financial statements of 2023 and 2024 are the ones where additional sales will show up and be converted into share price strength.
Why Invest in Undervalued Shares?
Investing in undervalued stocks presents opportunities for substantial potential returns if you can hold the position until ‘normality’ returns. As the explanation of valuation models highlights, determining ‘normality’ involves a degree of subjectivity, but if you make the right call, and can ride it out, then super-sized returns are possible.
Long-term investing can also be relatively light touch. Once you’ve carried out the necessary research to build a strategy and book your trades, monitoring positions can take up only a minimal amount of time.
What to Know Before Investing in Undervalued Stocks
Some stocks are ‘cheap’ because they deserve to be. However, even if your undervalued UK stock has all the potential catalysts in place for a future price surge, there can still be challenges along the way.
One factor to consider is opportunity cost. It can take time for the information that you used to pick your stock to feed through to the wider market. Until that happens, the capital tied up in your undervalued stock position can’t be used in other strategies.
Single stock risk is also a concern. There aren’t products such as exchange-traded funds (ETFs) that identify ‘undervalued stocks’. This means that you have to build your own portfolio, and that there are less options to diversify risk across a basket of different positions.
You may consider a whole sector to be undervalued, in which case you could by an ETF fund-style product. However, if you’re stock picking, risk management can come down to trading in small size and spreading capital across a number of stocks with the same characteristics. This does require a greater degree of work and ongoing risk management though.
In terms of practicalities, it’s also worth mentioning that as undervalued stocks can be a long-term investment, it’s more cost-effective to buy the shares outright rather than trade them in CFD form. This is important to keep in mind as most good brokers offer both CFD and share dealing accounts.
This article expands on the best approach to take to make sure that you trade as efficiently as possible.
HOW TO START TRADING STOCKS ONLINE
Market risk, the possibility that price might move in the wrong direction, is an unavoidable part of investing. There are other risks that need to be considered and managed. A lot of this involves applying a degree of common sense when working through the steps involved with opening an online investment account.
1. FIND A SAFE BROKER
The first and most important step is to ensure that your broker is legitimate. There’s no point worrying about ‘market risk’ and your undervalued stock not taking off yet if your cash is at risk from a scam.
Make sure that your chosen broker is regulated by a Tier-1 authority such as one of the below:
- Financial Conduct Authority (FCA)
- Australian Securities and Investments Commission (ASIC)
- US Securities and Exchange Commission (SEC)
- Cyprus Securities and Exchange Commission (CySEC)
2. FIND A BROKER THAT SUPPORTS TRADING IN UNDERVALUED STOCKS
Different brokers focus on different markets. Some, for example, specialise in providing no-frills, super-cheap access to the major forex markets. If you’re looking to scour the equity markets for diamonds in the dust, then you would do well to use a broker that offers a wide range of equity markets.
Brokers not only offer you the chance to buy, sell and hold shares, but also offer additional services such as news reports and system-generated price alerts.
If you are ready to add some undervalued stocks to your portfolio, you’ll need a broker that is regulated, has low fees, and has a user-friendly platform. Finding one can be a daunting task, which is why we’ve selected some of our favourites that tick all of these boxes to help you get started.
3. RESEARCH UNDERVALUED UK STOCKS
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4. OPEN AND FUND AN ACCOUNT
A lot of the work associated with onboarding to a broker is front-loaded. Spending some time trying out the demo accounts of a shortlist of candidates is highly recommended. Not only do you get to practice trading using virtual funds, but you also get a hands-on feel for the broker’s strengths and weaknesses.
Once that decision is made and you’re sure that your broker is safe, signing up for an account takes place online and can take as little as a few minutes. UK broker platforms have been designed with beginners in mind and the functionality is particularly user-friendly.
Your online broking account will appear very similar to any other online bank account. You’ll be the only person who has access to the account. Sending funds to it can be done using a variety of payment methods, including credit card, debit card and wire transfer.
5. SELECT AND BUY UNDERVALUED UK STOCKS
Once your account is set up and funded, you can start buying stocks and converting your cash into equity positions. Simply locate the market on your broker’s trading platform and enter the amount you want to buy. Depending on the strategy you are running, you might want to use stop-loss and take-profit orders. These are instructions built into the system to sell part or all of your position if price reaches a certain point.
You can use a desktop or mobile device, which makes putting your investment decision into practice as easy as clicking a button or tapping a screen.
6. POST-TRADING CHECKS
Investing in undervalued stocks can be a long-term play, so it’s important to check your portfolio before you leave the position alone and allow time to take its course. Even experienced traders make ‘fat-finger’ errors. Immediately after trading, it’s important to check that you bought what you wanted to buy and the right amount of it. Errors are best rectified before market prices move too far from your trade entry point.
The portfolio section of your account will show the basic data fields of your position. These include trade size, direction (buy or sell), and instrument name. Also, check if you bought the shares outright or in CFD format as the latter incur overnight financing fees, which can stack up.
Regular reviews of your position’s performance are, of course, advisable and will act as a reminder to check if any news events have occurred.
Warren Buffett famously once said: “Price is what you pay, and value is what you get.” His Berkshire Hathaway investment vehicle is famous for two things: focusing on undervalued stocks and making its investors staggering returns.
Between 1965 and 2021, Berkshire Hathaway targeted undervalued stocks and generated an annual gain of 20.1%, compared to the S&P 500 (with dividends) gain of 10.5%. If you can match Buffett’s buy-and-hold approach, and pick the right names, then similar kinds of returns could be heading your way.
When considering the risks involved, it is worth giving extra thought to your choice of broker. If you’re investing for the long haul, you’ll want to go with an established name that has a proven track record of supporting investors. This list of trusted brokers includes firms that have been reviewed by the AskTraders team to ensure that they offer all the services needed to get your trading off to the best possible start.