Over the last 60 years, Warren Buffett has generated a return of about 20% per year from the stock market. This has led to an extraordinary level of wealth for both him and his long-term investors.
What’s interesting is that Buffett’s strategy really isn’t that complicated (it’s actually very simple). So UK investors could potentially clone it and aim for an enormous ISA.
The secret is…
The secret to Buffett’s success really comes down to one key concept – compounding. This is the process of earning a return on previously generated returns.
A lot of investors understand the importance of compounding and use it themselves. What has set Buffett apart, however, is that he has used this process in two distinct ways. Let me explain.
A focus on ‘compounders’
Buffett started off as a value investor. And he had a lot of success with this approach. Yet over time, he realised that he could generate higher returns by investing in companies known as ‘compounders’. These are high-quality businesses that can continually reinvest their profits to generate growth and get bigger and bigger.
With these kinds of stocks, gains can be absolutely epic over the long term (unlike a typical value stock where gains drop off when the fair value is achieved). So he shifted his focus to these types of businesses (eg Apple) and held on to them for the long term while they compounded their returns internally.
Reinvesting success
Additionally, he compounded his own portfolio returns. Instead of paying dividends to investors (he only ever paid one from his company Berkshire Hathaway), he would reinvest all his gains.
This double use of compounding has paid off in a big way. Over the long term, it has led to gigantic returns.
My life has been a product of compound interest.
Warren Buffett
Copying Buffett
Given the simplicity of Buffett’s strategy, UK investors could easily replicate it. All they’d really need to do is put together a portfolio of high-quality compounders and hold the stocks for the long term while they get bigger and bigger.
Over the long run, this approach could lead to substantial wealth. Let’s say that an investor was to start out with £20,000 in an ISA, they added in another £10,000 every year, and they were able to generate a 9% return a year after fees. In this scenario, they’d get to £1m in about 25 years.
A Buffett-style stock
As for stock ideas, one compounder that could be worth considering today is Amazon (NASDAQ: AMZN). This is a stock Buffett currently holds in his Berkshire Hathaway portfolio.
Previously, Amazon has continually generated strong growth and then reinvested for future growth (expanding into new areas such as cloud computing, artificial intelligence (AI), streaming, and digital advertising). This had led to a huge increase in market-cap and exponential gains for investors.
Over the last decade, for example, the stock has risen about 10-fold. So anyone who has been in it for the long term has done well.
Of course, there are no guarantees that Amazon will be able to continue on this growth trajectory. Today, the company is facing plenty of competition in both e-commerce and cloud computing.
I’m optimistic about its long-term prospects however, given the company’s diversified nature. I’ve made the growth stock one of my largest holdings.
