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How can I find cheap shares in an expensive market?

Buffett at the BRK AGM

The idea of buying cheap shares for my portfolio always has appeal. But with the flagship FTSE 100 index within less than 1% of its all-time high, finding bargains might seem harder than usual.

I still think I might be able to find attractively priced shares to buy, however, even when the market overall looks expensive. Here’s why.

Price and value

A share price tells me one piece of information – what investors in aggregate are willing to pay for those company’s shares that are currently available to buy on the market.

But that does not help me know the underlying value of those shares. Sometimes, shares sell for more than they are worth. At other moments, they may sell for less than they are worth. That is a judgment I need to make myself, for example by looking at a company’s long-term financial prospects.

A market of stocks

On top of that, as the saying goes, it is a market of stocks not a stock market.

In other words, behind the headline numbers lie individual prices for each of thousands of different company shares. So some shares can be overvalued even when the stock market overall looks cheap. The reverse is also true: even close to a record level for the FTSE 100, I still think I can find attractively priced shares for my portfolio. In fact, despite the FTSE 100 flying high right now, quite a few shares look underpriced, not overpriced, to me.

How to find cheap shares

To search for such bargains, I would look for a mismatch between price and value.

So, for example, I might look at sectors that have fallen out of favour with investors but that I think have strong long-term prospects. An example is leisure. Pub chain J D Wetherspoon has lost 46% of its value in the past year – but I expect punters will still be sinking pints for decades yet.

I also look for companies with business models the market does not seem to properly understand. For example, I think a lot of investors look at a digital commerce company such as Victorian Plumbing and fear it could be swamped by competition from online giants like Amazon. By contrast, I see its wide product range, specialist focus and trade relationships as potential sources of competitive advantage.

Risk and reward

Some cheap shares really are bargains. But others are priced the way they are for a reason.

That is why, like Warren Buffett, I aim to include a margin of safety when assessing seemingly cheap shares I could add to my portfolio.

I also keep my shareholdings diversified at all times. That way, even if some of the stocks I buy turn out to be value traps, their negative impact on the overall performance of my portfolio will be limited. Wetherspoon might find that high costs keep hurting profits, for example. Victorian Plumbing could see sales fall as the housing market eases. So while I own both, neither has an outsized position in my portfolio.

Given my approach to valuing shares, I am always hunting for potential bargains in the stock market. Even though the market overall may be riding high, there could still be some real bargains on offer today.

The post How can I find cheap shares in an expensive market? appeared first on The Motley Fool UK.

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John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. C Ruane has positions in J D Wetherspoon Plc and Victorian Plumbing Group Plc. The Motley Fool UK has recommended 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.