Warren Buffett is arguably the most successful general investor the world’s ever seen. And one lesson he learnt early in his life was that the process of compounding can lead to life-changing returns from investments.
Buffett uses businesses as his vehicles of choice for compounding his gains. And he does so by buying shares listed publicly on international stock exchanges, or by owning businesses outright within his conglomerate company Berkshire Hathaway.
Warren Buffett’s focus on compounding
To me, the Buffett method means a focus on compounding achieved using investments backed by businesses. And to copy his approach as closely as I can, my plan involves investing in shares and share funds. But there will also be an emphasis on shareholder dividends from my investments.
I reckon dividends are one of the surest ways to compound investments. I’d aim to harvest that regular cash income from my share account and regularly reinvest it into my dividend-paying shares.
Of course, dividend income from companies isn’t guaranteed. Directors have the power to stop, or trim, dividends at will. And they often do if the underlying business performs poorly. But a focus on dividend sustainability could serve me well. So when doing my research into a business I’ll look for a record of strong cash flow and payments to shareholders. And I’d want a business to be showing a record of growth in earnings and revenue.
One opportunity that arises with expanding businesses is they often have a progressive dividend policy. And that means they aim to increase their payments to shareholders a little each year. And when business progress combines with a rising dividend, share prices can also adjust higher to reflect the improvements.
But that’s not always the case. Sometimes valuations are too high and share prices can remain immobile, or worse, they can decline despite a thriving underlying business.
Letting the businesses do the work
So aiming to buy shares at fair valuations is an important component of a strategy that aspires to use the Buffett method. But perhaps the most important piece of the puzzle is to hold investments for a long time.
After all, what’s really happening is that the businesses he buys into are doing the heavy lifting. He isn’t generally buying and selling shares regularly to compound his gains. Instead, he’s just holding onto his quality stocks and allowing the compounding to happen within the underlying businesses.
So compounding happens in my portfolio of investments when the underlying businesses show increases in revenue, earnings cash flow, shareholder dividends and the share price. And further increases build on those that have gone before. Indeed, the Buffett method is elegant in its simplicity. And I’m aiming to use it to generate an income of £500 a month from dividends.
If I can achieve an overall portfolio dividend income of around 4%, my sums show it will require a capital value of about £150,000 to deliver £500 a month. I believe that’s possible to achieve over time by regularly investing money while earning an average salary. But for me, the key to success is following the Buffett method.