World famous investor Warren Buffett has a surprisingly simple approach to investing. While some share pickers have very complex mathematical models or monitor thousands of charts each month, Buffett has a more straightforward approach to choosing stocks. I am following it to find cheap UK shares to buy for my own portfolio.
What Warren Buffett looks for
Buffett focuses on industries and businesses he understands. If he does not understand something he reckons he is unable to assess it properly. I think that is a helpful approach for me in hunting for cheap UK shares too. How can I assess whether a company offers me good value as an investor unless I understand the basic elements of its business model?
He looks for companies that have the likelihood of generating strong free cash flows in future. So he is basically looking to see whether a business has something that customers will still pay for in future but cannot easily be replicated by rivals. An example might be a product like the famous sausage roll at Greggs, a proprietary drink formula such as Irn-Bru at AG Barr or a distribution network it would be prohibitively expensive to replicate, like the one operated by Domino’s Pizza.
Hunting for value
The challenge is that Warren Buffett is far from the only investor who realises such attributes can help a company generate cash flows for decades. Many other buyers look for similar attributes. That can push the prices of shares up.
Just because a business can be very profitable does not make its shares good value. If they trade at too high a price, they could offer little return or even a loss to a shareholder over the course of several years, even if the underlying business is performing well. That is why valuation is important when considering which shares to add to my portfolio.
Buffett’s approach to valuation is to look for what he calls “great companies at good prices”. So he is not starting with the share price as many value investors do. Instead he starts the way I explained above – by looking for great businesses. Only then does he move on to consider a company’s share price.
Patience as a virtue
He will not necessarily buy shares even when he thinks the company is excellent. It depends on price. But he may watch a company – sometimes for years, or even decades. Occasionally a share price correction can offer him a buying opportunity. That may be a broad-based market crash, or it could simply be that a company he likes has seen its shares tumble after a profit warning.
I can apply that approach to finding cheap UK shares for my portfolio too. I have a shopping list of companies I would consider buying if their prices tumble in a market crash. But sometimes a company I like comes upon hard times for reasons of its own when the rest of the market is doing well. In such cases, I would also think about acting on the price movement and adding the stock to my portfolio.
Christopher Ruane has no position in any of the shares mentioned. The Motley Fool UK has recommended AG Barr and Dominos Pizza. 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.
