One key to building wealth as an investor is buying shares for much less than they are really worth. I am always on the lookout for cheap shares I can buy today and hold for the long term.
But a common refrain in life is that you get what you pay for.
So can dirt cheap shares really be the sort of wealth-building bargain I am looking for? I think the answer in some cases is yes. But I need to hunt carefully as I buy shares for my portfolio.
Business and price
Two key elements of a share valuation in my view are the business quality and the share price.
Business quality is important because over the long run if I own shares in a business that simply is not very good, then the chance of it turning out to be an amazing investment is low.
So rather than just looking at price, I always aim to buy only into quality companies.
Quality on sale
But if a business is so good, why would its shares be trading cheaply?
The answer is, if the market always worked efficiently, it should be hard to find very cheap shares relative to a fair valuation of the business concerned.
But markets can move in odd ways. That sometimes presents investors with real bargain-hunting opportunities.
Sometimes a piece of bad news can see a share price plunging, even though over the long-term a business seems unlikely to be largely affected by that news.
That is what happened when NCC issued a profit warning at the end of March, sending its shares down sharply. In the long run I think NCC’s business remains fairly solid. But many investors worry that one piece of bad news could be a sign of more to come later.
Sectors can also go out of fashion, leading to cheap valuations.
Consider UK banks like Lloyds and NatWest at the moment. They seem like very cheap shares based on the banks’ proven earning potential. That could be because investors see risks to profits in a weak economy. But it may also be because banks are simply not popular with investors at the moment and have been marked down in price accordingly. Time will tell.
Foresight and hindsight
Finding dirt cheap shares that will hopefully move up sharply in price later is an art not a science. Only with the benefit of hindsight can we know whether an investor fear that has driven a share price down is ultimately unfounded, or a legitimate reason to value the business lower.
By focusing on buying great quality, resilient businesses and assessing their risks carefully, I believe it is possible to identify some real bargains, especially during times of market panic.
Some dirt cheap shares really are a bargain – I just need to find them.
