After decades spent investing in the stock market, Warren Buffett has certainly learnt a few things. Fortunately for me and many other private investors, he is generous with his wisdom.
In fact, it is Buffett’s wisdom I have been following in my approach to buying cheap UK shares for my portfolio. Let me explain.
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Warren Buffett on price and value
Like a lot of people, Buffett started out as a “value investor”. Value investors look at a company’s earnings or assets and compare them to the share price. If they see that a company trades at a cheap-looking valuation – for example, the share price is just a few times its earnings per share – they may buy it as a potential bargain.
That approach can work very well. In some ways I still think like a value investor myself. But the approach has problems too. Companies that trade on very low price-to-earnings ratios may do so because the City does not expect them to maintain those earnings in future. For example, a company may have sold assets that mean its future profits will fall.
Buffett left behind pure value investing and instead started looking for deep value, not just focussing on share price. Deep value in this context is about how much profit a company can generate in future. If that number is big enough, the shares can still represent good value even though their price is high.
Looking for a business moat
To understand how a company might do in future, Buffett considers what they have that could set them apart from competitors when it comes to sustainable, substantial earnings streams. This type of competitive advantage is what Buffett calls a business “moat”.
Such a moat could come from a strong brand, for example. That is a key differentiator possessed by two of Buffett’s holdings, Coca-Cola and Apple. A moat could also come from an entrenched user network, as at Buffett holding American Express.
Whatever the source, such moats help companies grow their earnings over the long term. They can create enough value that a share seems like good value to Buffett even if its price is high.
Cheap UK shares
I am applying the Buffett method when it comes to hunting for cheap UK shares for my portfolio.
For example, I reckon Smith & Nephew has a wide business moat because many of its proprietary medical technologies have no immediate competition. Although the pandemic delaying elective medical procedures has hurt sales and profits, I think that will be a temporary blip. The long-term business moat of its technologies should help Smith & Nephew produce strong earnings for years to come.
I think the same is true of publisher Bloomsbury. Books in its Harry Potter series are the golden goose that keeps laying. A unique franchise like that provides a strong business moat, which could help Bloomsbury earnings for many years to come. Indeed, this week the company upgraded both revenue and profit expectations for the year. Potter’s appeal could peter out in future, hurting revenues and profits. But meanwhile Bloomsbury is growing its digital asset base and trying to fortify its business moat. Like Smith & Nephew, I would consider it for my portfolio.