I’m listening to Warren Buffett and loading up on cheap shares

Every investor has his own approach to picking stocks. But it’s usually a variation on a theme. I think the majority of investors expect to pay less for shares in a company than it is ultimately worth. While the theory of buying cheap stocks may sound simple, what about the practice?

That can be difficult. After all, millions of investors are trying to do the same thing. They usually have access to the same information. Although they can interpret the information differently or have their own take on what will happen in the future, if they really show it is a bargain then it can end up attracting a lot of attention. That alone can raise the price.

Hunt for cheap stocks

So what am I?

One approach is to learn from successful investors like Warren Buffett. They are not interested in buying stocks just because the price is low and may go up. Instead, Buffett focuses on the company’s long-term business prospects and assesses whether the current stock price offers relative value.

As he said of himself and partner Charlie Munger in this year’s shareholder letter, “no stock-pickers; we are business-pickers“.

Following this approach, the first thing I do when hunting for cheap stocks to buy is to identify businesses that I think have good long-term commercial potential. Examples include companies like Spirax-Sarcowith its specialist technology, and Victrexdue to the patent polymer.

Only when I have landed in that business I then consider the stock price.

How to calculate shares

It can be difficult to decide if a stock is really cheap.

That’s because I’m comparing the current price to what I think the business will be worth in the future – and at best that’s ultimately an educated guess. No one knows what will happen tomorrow let alone ten years from now.

But I can come up with different scenarios I think.

Currently, Spirax-Sarco is trading at a price-to-earnings ratio of 40. Even though the company is doing brilliantly in the future, the price still seems too expensive for my taste. So, while I may add the company to my portfolio at some point in the future, I don’t plan to do so now. After all, it’s the cheap stock I’m looking for.

Avoid the value trap

That share can be hard to find. Strong businesses with solid prospects often have a price tag to match.

Sometimes, I find what looks like a cheap stock. But research often pays off – I might discover that a previous source of income is about to dry up, for example, or that a large debt payment is about to fall due. Buffett’s initial purchase of Berkshire Hathaway precedent. In this year’s letter, he described it as “a venerable – but doomed – New England textile operation“. In other words, it is a value trap.

Usually low stocks are low for a reason – and no matter how much the stock price falls, it can still go down. So I spend time and effort digging into companies to try and avoid value traps.