Trading Strategies: a favourable risk/reward opportunity here

Risk and reward are inextricably linked. Investors seeking the prospect of higher rewards must accept they come with a greater risk of loss. Similarly, investors who are reluctant to take risk must be willing to forego the potential for relatively attractive returns.

Judging by valuations across the UK stock market, many investors currently appear to be relatively risk averse. Although the FTSE 350 index has risen by around 7% since the start of the year and remains within touching distance of its all-time high, a wide range of large and mid-cap shares currently trade at discounted prices and offer wide margins of safety.

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This, of course, is entirely understandable given the uncertain near-term economic outlook. Although inflation has now fallen to the Bank of England’s 2% target, the Old Lady of Threadneedle Street remains highly cautious regarding interest rate cuts. Given the inherent time lags of monetary policy changes, there is a very real threat that elevated interest rates will cause the economy’s 0.6% growth rate in the first quarter of the year to come under pressure over the coming months.

In addition, the result of the upcoming general election could yet hold some surprises. And, should there be a new government, changes to fiscal policy present a degree of uncertainty for stock market investors.

Long-term growth potential

However, the long-term prospects for the UK stock market are far more upbeat than its short-term outlook. While the exact timing and pace of interest rate cuts remain uncertain, Bank Rate is highly likely to fall over the coming years. This should have a positive impact on the economy’s growth rate, as well as on operating conditions for UK-focused firms. This could lead to higher profits and the potential for rising share prices. And with similar changes to monetary policy likely to be implemented in other developed economies such as the US and the Eurozone, the prospects for FTSE 350 stocks are set to improve.

Falling borrowing costs and a faster-growing economy are also likely to prompt improved sentiment among investors. A combination of reduced returns on cash, as well as a buoyant stock market, could tempt more investors to buy riskier assets such as shares. Indeed, history shows that investors are often drawn to those assets which have generated the largest returns over the preceding days, weeks and months. This rise in demand for shares could have a positive impact on the wider stock market’s performance.

Therefore, now could prove to be an opportune moment to purchase a wide range of discounted FTSE 350 shares. In many cases, their low valuations factor in short-term risks resulting from a delay to interest rate cuts. Their wide margins of safety also provide significant scope for high rewards over the long run.

Opportunities abound

Companies whose financial performance is most dependent on the economy’s outlook could offer the largest reward potential. In many cases, their valuations are currently particularly low due to a combination of tough operating conditions that have caused weak profitability and risk-averse sentiment among investors. As a result, they offer significant scope for capital gains over the long run as a mixture of low inflation, rate cuts and improving economic growth take hold.

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Of course, investors must ensure that any stock they purchase is fundamentally sound. The aforementioned short-term risks mean that a solid balance sheet which contains only modest amounts of debt is likely to prove crucial. Similarly, firms with a sustainable competitive advantage are set to be best placed to not only overcome short-term challenges, but also capitalise on improving operating conditions over the coming years.

Clearly, the level of risk taken by any investor is dependent on their own tolerance, time horizon and a variety of other factors. But for those investors who wish to obtain relatively attractive rewards, and are willing to accept elevated risks, the FTSE 350 currently offers a variety of favourable opportunities.

An improving outlook

Source: SharePad as at 25 June 2024.

FTSE 100-listed easyJet (LSE:EZJ), which currently offers a wide margin of safety, is a good example. The budget airline’s share price has fallen by around 9% since the start of the year, thereby lagging sector peer IAG’s near-9% gain over the same period, and now trades on a price/earnings (PE) ratio above 10 but under 7 on a forecast basis. This suggests that it offers good value for money given its long-term growth potential.

Indeed, the company is set to experience improved operating conditions after what has been a tough period for the travel and leisure sector. Inflation which is now in line with the Bank of England’s 2% target means that extreme pressure on consumer spending brought about by a cost-of-living crisis has at least begun to lessen . Furthermore, with wage growth being ahead of inflation, and the economy’s improving prospects amid upcoming interest rate cuts likely to have a favourable impact on employment levels, the outlook for spending on discretionary items, such as leisure flights and holidays, is increasingly upbeat.

Moreover, a buoyant outlook for the airline industry is likely to have a positive impact on easyJet’s financial performance. According to the International Air Transport Association (IATA), passenger numbers in Europe are set to rise at an annualised rate of 5.4% over the next three years. And over an extended timeframe, the IATA expects global passenger numbers to increase by 3.8% per year on average between 2023 and 2043.

Stronger performance

easyJet’s latest half-year results showed that it is making encouraging progress in implementing its growth strategy. The company’s pre-tax losses narrowed by £61 million to £350 million, with a 12% rise in capacity and flat unit costs (excluding fuel) being key contributors. Its holidays division, meanwhile, recorded a 42% growth rate in customer numbers, with it expected to produce pre-tax profits in excess of £170 million in the current year.   

The company plans to reduce costs by ordering larger, more efficient planes to replace part of its existing fleet over the coming years. This should aid it in achieving its goal to generate pre-tax profits that are in excess of £1 billion over the medium term. This would represent a more than doubling of last year’s figure of £455 million.

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As well as offering significant long-term reward potential, easyJet is effectively managing its risks by having a solid financial position. It currently has a net cash position of £146 million, while its total liquidity amounts to around £5 billion, which suggests it is well placed to overcome short-term economic or industry-related challenges.

Furthermore, it could be argued that demand for the company’s services is more resilient than may appear at first glance. Although leisure travel is classed as a discretionary item, some consumers may consider an annual holiday to be more akin to essential spending. Therefore, while the potential for economic uncertainty in the short run may weigh on the firm’s financial performance, it may not have as great an effect as some investors anticipate.

While easyJet’s upcoming change in CEO would normally present a risk for investors due to the potential for a shift in strategy, the promotion of the firm’s current CFO means a drastic alteration to its growth plan is relatively unlikely. Given that its shares trade on a low valuation and the company is set to benefit from an improving operating environment, it appears to offer a favourable risk/reward opportunity for the long term

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.