After the recent stock market crash, many UK investors are looking for cheap FTSE 100 stocks to buy. That’s understandable, as the key to making money from the stock market is to buy low and eventually sell high.
However, the thing to understand about cheap shares is they don’t always end up being good investments. If you’re thinking about investing in cheap FTSE 100 stocks, there’s a piece of advice from Warren Buffett that I think you should read first.
Buffett’s view on cheap stocks
When he first started out investing, Buffett was your classic ‘value’ investor. In other words, he looked for cheap stocks that were undervalued, relative to their intrinsic value. His aim was to buy low and sell high.
Yet, over the years, Buffett has evolved his strategy. Today, he prefers to invest in high-quality businesses that are extremely profitable and have strong balance sheets, instead of just buying stocks simply because they’re cheap.
The reason Buffett changed his strategy? He came to the conclusion that cheap stocks are often cheap for a reason. “The original ‘bargain’ price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen,” he wrote in his 1989 letter to Berkshire Hathaway investors.
Buffett still likes a bargain, of course. However, his advice to investors is to focus less on valuation, and more on the quality of the underlying business. This is because, in the long run, high-quality companies tend to be the best investments. “It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price,” he says.
Terry Smith agrees with Buffett
This investment philosophy is shared by Fundsmith portfolio manager Terry Smith, who is often referred to as ‘Britain’s Warren Buffett’. In his recent letter to Fundsmith investors, Smith said: “Most of the stocks which have valuations which attract value investors have them for good reason — they are not good businesses.”
Smith also believes that investors are better off focusing on high-quality businesses instead of picking stocks just because they’re cheap. Given the fund manager’s phenomenal track record (he’s turned £1k of investor money into nearly £5k in less than a decade), his views are probably worth listening to.
Cheap FTSE 100 stocks
The takeaway here is that buying FTSE 100 stocks just because they’re cheap may not be the best investment strategy. Cheap shares can stay cheap, or worse still, get even cheaper. Just look at BT Group. People were saying it was cheap at 200p last year. Now, it’s trading near 100p.
Instead of buying stocks simply because they’re cheap, I think you’re better off investing in brilliant businesses that are highly profitable, have competitive advantages, and have strong long-term growth prospects.
These kinds of stocks may not be the cheapest you’ll find, but they tend to be excellent investments over the long term. Buy these kinds of stocks at the right time, when they are cheaper, and the chances are you’ll do well in the long run.
Edward Sheldon has no position in any shares mentioned but has a position in Fundsmith. The Motley Fool UK has no position in any of the shares mentioned. 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.