The fall in the US stock market over the past week is sharp enough to be defined as a stock market crash. Here in the UK, the 10% fall in the last week is more in correction territory. Aside from the jargon, many investors like myself are searching to sift through the market to find cheap shares. Here’s how I do it.
Ignoring the bottom 10%
Filtering for the stocks that have seen the largest share price fall in the recent past is a good starting point for looking for opportunities. However, I always discount the worst 10%. This is because there will always be some companies that genuinely will struggle as a result of the crash.
In this case, I’m referring to the US tariffs. For example, take Aston Martin Lagonda (LSE:AML). The stock is down 29% over the past month when tariff chatter started to get serious. It is now down 64% in the last year. Yet the company hasn’t just been caught up in poor sentiment. The tariffs will genuinely impact its financials.
The 25% import tariff means Aston Martin cars sent to the US will be more expensive. If the increase is added to the car price, this could lower sales volumes. If the business keeps the price the same, profit margins will be eaten away rapidly.
Further, the impact could reach other markets around the world. For countries impacted by the tariffs, customers could cut back on spending due to weaker economic growth. In this case, luxury brands like Aston Martin could be hit hardest as the cares are not necessities.
In my view, the risk is in whether Aston Martin is able to sustainably grow the domestic UK market to offset the external hit or tariffs are removed fairly quickly.
Focus on valuation
After looking at stocks that have fallen (outside of the worst 10%), I compare the share price movements to changes in valuation. I like to use the price-to-earnings (P/E) ratio. Just because a stock has fallen 10%, the P/E ratio could still be very high, indicating it’s still overvalued.
A benchmark figure of 10 is what I use when trying to pin down a fair value. So in terms of targeting cheap shares, I’m looking for stocks that have dropped to such a level that the ratio has moved below 10. In theory, the lower the ratio the better, but there are exceptions to every rule!
Sectors of the future
To drill down even further, I take the fallen stocks with a low P/E ratio and then group the remainder into sectors. From here, I’m looking for areas that I think could do well in years to come. This would include the likes of renewable energy, AI, and healthcare.
If there are stocks in this category, I believe they are more worthy of being called cheap shares because the value further down the line should be greater. This contrasts with a shrinking sector, where the stock might look good value now but has limited scope to recover in the future.
