Over the last couple of weeks, many stocks became cheaper because of another pullback in the markets. And times like this are perfect for hunting out cheap UK shares.
In his long investing career, multi-billionaire investor Warren Buffett made much of his money buying shares in good-quality businesses, something that can be seen from his annual Berkshire Hathaway shareholder letters. But he always had an eye on valuation. So, when the markets were weak and uncertainty filled the air, he was often found making some of his most lucrative stock purchases.
What is a cheap UK share?
Volatility returned to the stock market last week after what has been an amazing rally since the spring lows. And some have branded that long uptrend a ‘lockout’ rally. Why? because disbelieving investors often stand on the sidelines waiting for the ‘inevitable’ correction before buying. But the correction never seems to arrive. Shares just keep going up and those investors are effectively locked out of participating in the markets.
However, shrewd investors like Warren Buffett, Mark Minervini and many others did buy shares in the spring when the market was offering lower valuations. And they’ve prospered mightily since with many of those bargain purchases. But buying when the market is down can be psychologically hard to do. And that’s because falling share prices tend to reflect economic uncertainty ahead.
But to me, a cheap share is characterised by the way it assigns a lower valuation to the underlying business. And lower valuations go hand in hand with murky outlooks. However, Warren Buffett and others tend to ignore the worries of the day and focus on the prospects, quality and other attractions of the underlying enterprise.
Hunting for great businesses
Indeed, there’s nearly always something to worry about. And that’s why we have the popular aphorism ‘stock markets climb a wall of worry’. But when Covid-19 hit the markets, nearly all shares plunged because nobody knew what would happen next. Yet as the crisis has developed, it’s become clear that some businesses can prosper in the current environment. In other words, the ‘good’ shares were dragged down with the ‘bad’.
So those buying the shares of good-quality businesses near the lows have done well as the stocks recovered. And I think most investors have a shot at making a million from cheap UK shares if they buy when the stock market is down. The key is to focus on the quality of the underlying operation. Warren Buffett, for example, sold out of his stocks in airline companies when the pandemic hit. I reckon he did that because he knew airline businesses are poor-quality, cyclical operations.
Meanwhile, the recent market retrace is a healthy sign in an ongoing bull market because it blows off some of the speculative froth from valuations. The pullback also gives investors another opportunity to focus on buying cheap UK shares representing solid, good-quality underlying businesses. The correction may have arrived. So right now, I’d tune out the economic ‘noise’ and tune in to the spirit of Warren Buffett. That means working even harder on my watch list with a view to buying the marked down shares of good companies.
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Kevin Godbold has no position in any share mentioned. 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.