As an investor, I can try to reinvent the wheel. Or I can look at what very successful investors have already done and seek to apply relevant lessons to my own approach.
That is what I am doing this year, by using inspiration from billionaire Warren Buffett while hunting for cheap UK shares I can buy for my portfolio.
Price versus value
When Buffett looks for cheap shares, that does not mean he is looking to buy for pennies. The price of a share on its own does not make it cheap. What makes a share cheap (or, indeed, expensive) is its price relative to the value it offers.
Take BT as an example. Currently, I could buy around four BT shares for £5. But whether that is cheap or not depends on how I value BT. How much demand will there be in future for its services? Can it use unique assets like its Openreach division to help make profits? How is the value affected by liabilities such as borrowings, or its ongoing obligations to pensioners who used to work for the company?
Valuing a company is not easy – as this example shows, there are a lot of variables at play. But as an investor willing to do my homework, that can actually help me. If company valuation was clear and easy, I think many shares would be more efficiently priced than they are.
It is precisely because valuation is often an art not a science that different investors can end up ascribing their own value to a particular share. If that means I can buy a share for a much lower price than what I see as its long-term value, there could be an opportunity for me to boost my wealth.
UK shares on sale
Right now, I am applying that approach to my hunt for shares I can buy for my portfolio.
One example is my purchase of Superdry shares towards the end of last year. The fashion retailer has secured a new lending arrangement and sales have been growing. Despite that, its shares trade on a price-to-earnings (P/E) ratio of under 6, even after rising sharply in the past several weeks.
How could I go about finding more shares for my portfolio that trade very cheaply relative to their long-term value? Simply looking at valuation metrics like P/E ratios on their own can be misleading. A P/E ratio does not tell me anything about a company’s debt load, for example, or whether its earnings are about to fall off a cliff.
Hunting for quality – and value
Instead, I hunt around in areas I feel I understand and look for companies I think have a unique competitive advantage. That is also what Buffett does, focusing on business sectors he understands well, like insurance and transportation.
When I find such companies, I then consider their valuations, taking into account their future business prospects and things like debt. If they look a bit cheap, I still may not buy them as I would not have much margin of error if my valuation turned out to be optimistic. But if they look dirt-cheap, I will consider adding them to my portfolio.
