Legendary investor Warren Buffett has been very successful. He has patiently refined his approach to selecting, buying, holding, and selling shares. I think I can also profit following Buffett’s principles, by buying cheap UK shares. Here is how.
Warren Buffett’s approach to valuation
Different investors use a variety of approaches to value a company’s shares. Many will look at its price-to-earnings multiple, for example.
Buffett’s approach starts with considering how much profit a company might make in future. Clearly that can be difficult, as many variables could affect the outcome. So Buffett considers what factors may help a company sustain profits. For example, if it has a unique solution to a customer problem in the form of a patented technology or local monopoly, that could help.
Future risks
As those potential earnings are in the future, they have less value than the same money in hand today. Buffett discounts such future cash flows accordingly. If a company’s current value is markedly below likely discounted future profits, it may be an attractive investment for him.
The future profits are a projection. All sorts of problems might arise in the meantime to drag them down. That is why Buffett – and many other investors – look for a “margin of safety”. With such an approach, an investment could still turn a profit even if the company’s future profit is somewhat lower than projected.
Buffett summarises this approach as looking for great companies at good prices. So for him, “cheap” is not just about a price. It is about the possible future value one can unlock as an investor at a share’s current price.
Hunting for cheap UK shares
Using Buffett’s criteria, I think the UK stock market offers shares that might fit my criteria — at the right price.
For example, self-storage provider Safestore is a leader in its industry. Its well-established brand and the hassle of moving items between storage providers means that many customers will keep using its service for months or years. That is the sort of economic ”moat” Buffett likes. It gives Safestore pricing power. That helps explain why the company announced last week that revenue grew 15% last year. The total dividend for the year increased 35%.
Another company I think has a strong moat is vehicle sales platform AutoTrader. Its network effect means the more business it attracts, the more desirable it becomes to advertisers. That gives it pricing power. The iconic brand could keep it in pole position for car sales in coming years.
Risks and market fear
Such attractive attributes are often spotted by investors, though. Share prices can move up accordingly. But all companies also carry risks. Barriers to entry in self-storage are low, for example, which could hurt Safestore’s profitability if a new entrant launches a price war. Increased competition from platforms like ebay could hurt revenues and profits at AutoTrader.
When the market is fearful, such risks can drag down the share price of great companies a long way. Like Buffett, at those moments I would be happy to scoop up such shares for my portfolio. Those windows of opportunity can be narrow. So now is the time for me to make a shopping list of great companies I would like to buy, if their shares fall to a price I find attractive.
