If I wanted to start investing in shares, one question I would have is where to begin. Should I buy US or UK shares? What about growth or income? Should I focus on FTSE 100 names or smaller FTSE 350 companies?
The answers would depend on my own personal investment objectives. Personally, I would start hunting for cheap UK shares to build my portfolio. Here is why.
I would start investing by hunting for long-term value
Cheapness is not just about price. Rather, it is a combination of price and long-term value. I would want to consider whether what I pay for a share today is a bargain relative to how much it will be worth in years to come.
But nobody knows what a given share will be worth tomorrow, let alone a decade from now. That is why when I look for value, I try to build a margin for error into my calculation. If I think today’s share price is only fractionally below the value it will generate over the long term, I would not feel it is worthwhile for me to buy it. After all, results can disappoint and changing industry conditions can hurt a company’s profit. So I look for situations in which I think the current price substantially undervalues a share relative to its potential future value.
What makes a share valuable?
But how can one judge what the potential future value of a share might be?
It is definitely an art, not a science. I think it can be helpful to remember that just as its name suggests, a share basically represents a fraction of the excess cash a company may generate in future. So I look for companies that I think will have the means to generate large amounts of excess cash.
To do that, I consider what assets a company may have that will enable it to do that. Those could be things like proprietary technology, strong brands with loyal customers, reserves of natural resources, or a monopoly in a certain area.
Cheap UK shares
Right now, UK stock markets trade on lower multiples than in some other countries. So quite a few UK shares seem cheap to me.
If I was to start investing for the first time, I also think UK shares would be an easier place for me to begin simply in terms of market understanding. From Greggs to Next and Stagecoach to Smith & Nephew, I am already familiar with many businesses as a customer. If I started looking for shares in, say, Canada or Spain, that would likely not be the case.
But my personal experience would only be one part of my assessment approach to finding cheap UK shares I could add to my portfolio. After all, a good business does not necessarily make for a rewarding investment. My investment returns will depend on the price at which I buy a share. To assess that, I need to have some sort of framework to judge whether a share is trading cheaply relative to its long-term potential value. That is why I look for shares based on understanding their source of competitive advantage and profitability, not just their current share price.