Warren Buffett is among the most successful investors of our age. The 92-year-old has amassed a fortune worth over $100bn.
But what makes him so successful? Well, he uses a value investing strategy. This is an investment approach involving picking stocks that appear to be trading for less than their intrinsic or book value.
Over the last century, a value investment strategy has more often than not outperformed index returns in most markets. So, how can I look to emulate the so-called Oracle of Omaha?
Undervalued stocks
Investing in undervalued stocks is an integral part of the value investing strategy. But I’ve got to find them first.
This is where I need to do my own research.
There are simple, near-term metrics like the price-to-earnings ratio, or enterprise value-to-EBITDA. Then there are the more complex ones, such as the discounted cash flow (DCF) model.
These metrics can help establish an idea of the discount on offer. Buffett is known to look for a margin of safety around 30%, or even higher. That means, the perceived value of the stock is around 30% higher than the share price.
UK stocks
Buffett doesn’t appear to have much interest in UK-listed stocks. But that’s maybe because he likes to stick to what he knows best.
However, I can apply his teaching when investing in British stocks. And right now might be a good time to put these learnings into practice.
That’s because many parts of the FTSE are depressed right now. And this is the market in which I’m most likely to find undervalued stocks.
Undervalued picks
British banks are a good place to start when looking for potentially undervalued stocks. DCF calculations suggest that both Lloyds and Barclays are undervalued by up to 60% and 70% respectively.
This is great, because Buffett tells us to focus on quality, and these are quality institutions.
Both stocks are seeing revenues grow on the back of higher interest rates. But higher rates are a double-edged sword. With customer repayments rising and the economy slowing, the proportion of bad debt on their loan books is increasing.
Yet despite recession concerns, the high interest rate environment appears to be a huge tailwind for banks.
I’ve topped up on both of these stocks within the last month. But I’d still buy more now.
Rolls-Royce is another undervalued pick I’m buying more of. Calculations suggest it’s undervalued by as much as 50%.
There are naturally concerns that debt may weigh on future cash flow (but Rolls is a much leaner business than it used to be). It’s also more difficult than usual to forecast future cash flow as the business has really changed over the past three years.
I’m a little concerned about new CEO Tufan Erginbilgic labelling the engineering group as a “burning platform” which was on its last chance. But broadly, he seems confident that performance could improve. And I’m optimistic too.
My final pick is Airtel Africa. The DCF calculation suggests a fair value of 500p, which is considerably higher than the current price of 117p. It operates in a highly competitive sector, but there’s clearly huge growth potential in the African telecoms and payments market. That’s why I’m looking to add it to my portfolio.
