As an investor, how can I aim to increase my wealth? Put simply, I try to buy shares for less than I think they are worth. In fact, as I aim for a margin of comfort, I try to buy them for much less than they are worth. But of course thousands of other investors are doing the same thing, many of them with far more sophisticated tools than I use as a private investor. Given that, how do I try and find cheap shares to buy for my portfolio?
The concept of value
I think it is helpful to understand what makes something cheap.
For example, is a £1m house cheap? Some people would immediately say no, as it costs a million pounds. But what if it is a mansion in the heart of Knightsbridge? As this example illustrates, price alone does not give us enough information to know whether something is cheap. It also matters what that thing is.
So, for example, a share costing 90p might be cheap – or it could be expensive. As an investor, what I am looking for is value. Getting value, in my view, involves paying less for something than it is worth. So whether that 90p share is cheap depends on how its price compares to what it is worth.
As billionaire investor Warren Buffett says: “price is what you pay, value is what you get”.
Hunting for value
Clearly, though, most sellers would not be happy selling a share for less than they know it to be worth. So, why would I ever be able to find cheap shares?
The answer to this is that nobody ever knows for sure what a share is worth. Deciding how to value shares includes a lot of assumptions, which can turn out to be wrong.
For example, how would you answer if I asked you what shares of Ocado are worth?
The company looks set to keep growing revenues. But to do so it needs to spend money on infrastructure. Indeed, it raised more funds from investors just last week, partly for that very purpose. Meanwhile, the growth in demand for digital retail remains uncertain. Many investors expect it to keep growing – but for how long?
The range of assumptions and variety of possible answers involved here helps explain why Ocado shares have fallen 60% in the past year.
Ocado is just an example. Valuing any share involves making assumptions. That is why different investors are willing to pay higher or lower prices for the same shares.
Finding cheap shares to buy
That gap between my valuation and that of other investors can help me find cheap shares to buy.
For example, other investors may be more negative than I am about a company’s sales and earnings prospects. That is why I recently bought into Dunelm. Its shares have fallen 41% in the past year. But I do not think its ability to generate profits over the long term is 41% lower now than it was 12 months ago.
As long as I focus on value not just price, I think I can take a methodical approach to finding cheap shares to buy for my portfolio. Hopefully that can improve my returns over the course of time.
