Warren Buffett has built a considerable fortune over the past seven decades by investing in undervalued equities. I believe it is also possible for me to achieve attractive investment returns by using a similar approach with UK shares.
I am looking for equities that appear cheap compared to their potential over the long run, although I will not buy a stock just because it looks cheap.
Before I acquire any investment, I need to be sure it has the potential to grow over the next couple of years. If a business faces years of shrinking earnings and also has a weak balance sheet, it seems unlikely it will produce positive returns for investors.
With that in mind, here is the investment strategy I would use to uncover cheap UK shares.
The Warren Buffett strategy
When Buffett is looking for stocks to add to his portfolio, they must exhibit two qualities. Firstly, these businesses must be high-quality enterprises. This means they must have strong profit margins and unique competitive advantage. These qualities will help them stand out from the competition.
Secondly, to make it into Buffett’s portfolio, investments must also appear undervalued compared to their potential.
One company that I think currently looks fits the bill is S&U, a business that provides short-term financing solutions for customers.
It is still majority-owned by its founders, and I think this gives the business a competitive edge. S&U’s founders want to achieve the best returns. Therefore, they will likely stick to the best deals and not try to grow at any cost, which could dilute profitability.
As Buffett does not tend to invest in the UK, I do not think he would buy this stock for his portfolio. However, I think it ticks all the boxes of a Buffett-style investment. That is why I would add it to my portfolio of cheap UK shares.
Rightmove is another company on my list. The business is one of the most recognised websites in the UK. It dominates the online property market, and as long as the corporation continues to invest, I think it is unlikely it will lose this position anytime soon.
Considering its growth potential over the next couple of decades, I think the stock looks undervalued.
Challenges with cheap UK shares
I would buy both of these companies for my portfolio, but following Buffett’s approach is not that easy. The investor spends a vast amount of time analysing the risks of his investments and any challenges they may face.
When it comes to Rightmove an S&U, these companies could face competitive challenges and rising costs, which may eat into their profit margins. Economic disruption in the UK could also de-stabilise growth.
Still, even after taking these risks and challenges into account, I would buy both Buffett-style firms for my portfolio today. Compared to other cheap UK shares, I think these businesses stand out.
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Rupert Hargreaves has no position in any of the shares mentioned. The Motley Fool UK has recommended Rightmove and S & U. 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.