The famous investor Warren Buffett uses a lot of simple but effective investment techniques to improve his likelihood of success.
Here are two Buffett approaches I use to try and improve the returns of shares in my ISA.
Focus on long-term advantage
Buffett has a laser focus on the question of what sort of long-term advantage a company can enjoy from its business model. Take as an example his ownership of the Burlington Northern and Santa Fe Railway. This is the largest freight railway in North America. The prohibitive cost of building a railway network means no one else is likely to replicate it. But demand to move freight across the US and beyond will remain high for decades to come, if not centuries. So the railway has exactly the sort of long-term profit generating potential Buffett looks for when it comes to buying businesses.
I think the same sort of long-term focus on a business’s ability to generate profits could help me pick better performing shares for my ISA. For example, one of the reasons I do not own detergent maker McBride is because its manufacturing model puts it close to being in a commodity market. There are costs and knowledge required to set up and run a detergent factory, so McBride does have some competitive advantage – but I see it as a thin one. By contrast, companies such as Reckitt or Unilever own iconic brands no competitor can exactly match. That gives them an enduring source of pricing power, which can translate into higher profits.
Profits today not just prospects tomorrow
Another part of Warren Buffett’s investment approach is his focus on companies that have already shown their cash generation potential. Buffett’s investments, no matter how they are doing when he buys them, have all demonstrated at some point an ability to generate business profits. Buffett does not invest in companies that have consistently lost money throughout their history in the hope that in future they will find some magic formula for profitability.
That is one reason I do not own loss-making companies like ITM Power in my ISA. Sure, ITM has some promising technology that could turn out to be profitable in future. But so far, it has not. By contrast, other companies in the power generation and distribution space already have proven business models to make profits.
For example, power distributor National Grid is profitable and its existing network gives it the sort of competitive advantage Buffett loves, much like the railway he owns. So while I would not buy ITM Power for my ISA, I would consider purchasing National Grid. High network maintenance costs could yet eat into profits at National Grid. That sort of risk is exactly why I always diversify my ISA across different companies.
Warren Buffett and ISA returns
Individual shares can do well in the short term for all sorts of reasons.
But in the long term, I think Buffett’s method of identifying promising investments makes sense for me. Not only by buying shares in good companies, but also by avoiding stocks that seem promising but end up disappointing investors, I hope that over time I can boost my ISA returns.