I listen to Warren Buffett and buy those cheap stocks!
Naturally, we all want to replicate what the so-called “Oracle of Omaha” did. Buffett uses a value investing strategy, and value investing strategies have consistently outperformed the index over the past century.
So how can I invest more like Buffett, and what does that mean for my stock selection?
Value investing involves selecting stocks that trade at a price below their intrinsic or book value. This gives us a margin of safety. Buffett is known to look for a margin of safety of around 30% or more.
Calculating this margin of safety requires investors to undertake fundamental analysis. This analysis revolves around indicators such as the discounted cash flow (DCF) model and short-term valuations such as the EV/EBITDA ratio.
This value-driven approach to investing often requires a contrarian mindset, that is, not following the crowd and having a long-term investment horizon.
Discounted FTSE shares
The FTSE100 could push higher, but many stocks are trading discounted in the UK. This is because the indices have been pulled higher by the surge in resource stocks. The FTSE250 is more illustrative of the challenges UK businesses have faced – it was down 8% over the year.
So in the midst of this bear market, I think now is the time to find some undervalued UK stocks that might meet Buffett’s criteria.
But he also tells us to focus on quality as well as discount, saying he’d rather pay a fair price for a great company than a good price for a fair company.
Barclays is an unloved British bank. Many UK financial institutions have not been popular with investors for some time. And that’s why I see it as an interesting sector of the market. A DCF model with a 10-year exit suggests Barclays could be undervalued by up to 68%.
Analysts expect Barclays could also benefit as much as £5 billion over the next two years from rising interest rates.
Currently, it is the cheapest UK financial institution, with a price/earnings ratio of 4.8. This will reflect some of the challenges of the last 12 months – fines and impairment charges – but it’s a good starting point for my investment.
Another choice is the medical equipment specialist Blacksmith and nephew. This stock has suffered since the start of the pandemic as national resources have been redirected towards Covid and away from hip replacements.
A DCF model with a 10-year exit suggests the company could be undervalued by up to 40%. 2023 should be a better year for the company as Covid becomes less of a problem in healthcare and the backlog of elective surgeries is addressed. However, inflation will remain a challenge, putting pressure on margins.
In the long term, I am particularly optimistic. We have an aging population, which will lead to an increasing demand for elective surgeries over the coming decades.
I recently stocked up on both of these stocks.