It certainly has been a volatile 12 months for the Australian share market in 2022. This has seen a number of ASX shares tumbling deep into the red over the last 12 months.
While this is disappointing for investors, it may have created an excellent buying opportunity.
However, before rushing in, investors may want to listen to some of Warren Buffett's advice about cheap shares first.
Cigar butt investing
In Berkshire Hathaway's 1989 letter, Mr Buffett warned investors to stay away from terrible companies even if you could make a quick profit. He said:
If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long- term performance of the business may be terrible. I call this the "cigar butt" approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the "bargain purchase" will make that puff all profit.
Instead of cigar butt investing, the Oracle of Omaha thinks investors should focus on making long term investments in "wonderful" companies. He adds:
Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original "bargain" price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre.
Buffett then famously concludes:
It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner.
