The FTSE 250 can offer some growth bargains. But here are 3 risks to watch out for!

The FTSE 250 index contains listed companies with smaller market capitalisations than those in the flagship FTSE 100 index.

That can mean some smaller companies with big growth prospects are in the index. With less focus on it than the FTSE 100, the index can also offer some potential bargains that not all investors have spotted. I aim to find such bargains – but here are a trio of risks I am mindful of when doing so.

Confusing cyclical growth with sustainable growth

Some companies are able to grow their business over the long term. Others grow fast during an upwards move in their business cycle, before revenues and profits crash back down when the cycle changes.

That can be a risk for companies of any size that operate in cyclical industries. But smaller businesses can, by their very nature, be less diversified in their operations, magnifying that risk.

For example, Atalaya Mining Copper SA has performed brilliantly in the past five years. The FTSE 250 share has more than trebled in value during that period.

But its focus on one main metal (copper) and one main production area (Spain) offers a level of concentration risk different to that seen in a FTSE 100 miner like Rio Tinto.

When I see a FTSE 250 share with a track record of growth, I try to understand how sustainable that growth may be over the long term, including across the economic cycle.

Underestimating the importance of liquidity

When tight times arrive – as they do from time to time – cash is king. Even large FTSE 100 companies can find that access to credit lines becomes harder, or dry up altogether.

Getting enough liquidity when everyone else is screaming for cash can be even more challenging for smaller companies. When investing, I look at the balance sheet of a company no matter what its size.

That certainly includes FTSE 250 businesses. Some spend heavily on growth, racking up large debts. At the wrong moment, that can be deadly.

Avoiding what you don’t understand

I always try to stay inside what Warren Buffett refers to as my “circle of competence” when investing.

New, emerging companies that grow fast will typically enter the FTSE 250 before they ever get close to the FTSE 100. So I try to be careful not to get sucked into the hype and stick only to businesses I feel I understand. That is important because otherwise investors cannot properly assess their value as an investor.

As an example, my holding in Topps Tiles (LSE:TPT) has not done well, so far. So I have had to consider what to do: hang on, sell, or use a weaker share price to top up my holding in the FTSE 250 building materials supplier after its share price fell 10% in the past year.

To do that, I have looked at the company’s accounts. I take some cheer from strong sales in recent years, with acquisitions of trade and digital platforms offering more scope for growth.

Last year, the firm fell to a £13m net loss and cut its dividend. I see a risk that weak consumer confidence could lead to less spending on home renovation, hurting profits.

But Topps’ business has started this year encouragingly and I plan to keep holding the share.

The post The FTSE 250 can offer some growth bargains. But here are 3 risks to watch out for! appeared first on The Motley Fool UK.

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C Ruane has positions in Topps Tiles Plc. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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