Each investor has their own approach to choosing shares. But mostly it boils down to a variation on a theme. I reckon the majority of investors are hoping to pay less for a stake in a company than it ultimately turns out to be worth. While the theory of buying cheap shares might sound simple, what about the practice?
That can be difficult. After all, millions of investors are trying to do the same thing. They mostly have access to the same information. Although they may interpret that information differently or have their own take on what will happen in future, if a share really is a bargain then it may end up attracting a lot of attention. That in itself can drive up the price.
Hunting for cheap shares
So what do I do?
One approach is to learn from successful investors like Warren Buffett. He is not interested in buying shares just because they have a low price and it might go up. Rather, Buffett focuses on the long-term business prospects of a company and assesses whether its current share price offers value compared to that.
As he said about himself and partner Charlie Munger in this year’s shareholder letter, “are not stock-pickers; we are business-pickers”.
Following that approach, the first thing I do when hunting for cheap shares to buy is to identify businesses I think have excellent long-term commercial potential. Examples include firms like Spirax-Sarco, with its specialist technology, and Victrex, due to its patented polymers.
Only once I have landed on such businesses do I then consider their share price.
How to value shares
It can be difficult to decide whether a share really is cheap.
That is because I am comparing today’s price to what I think the business will be worth in the future – and at best that is ultimately an educated guess. Nobody knows for sure what will happen tomorrow let alone a decade from now.
But I can draw up a range of what I think are likely scenarios.
Currently, Spirax-Sarco trades on a price-to-earnings ratio of 40. Even if the company does brilliantly in future, that valuation still looks too expensive for my tastes. So while I might add the company to my portfolio at some point in the future, I do not plan to do so now. After all, it is cheap shares I am looking for.
Avoiding value traps
Such shares can be hard to find. Strong businesses with solid prospects often have a price tag to match.
Sometimes, I find what look like cheap shares. But research often pays off – I may discover that a prior source of earnings is about to dry up, for example, or that a massive debt payment is about to fall due. Buffett’s initial purchase of Berkshire Hathaway is an example. In this year’s letter, he describes it as “a venerable – but doomed – New England textile operation”. In other words, it was a value trap.
Often cheap shares are cheap for a reason – and no matter how far a share price falls, it can still fall further. So I spend time and effort digging into companies to try and avoid value traps.
