Warren Buffett is certainly an extraordinary investor. According to his most recent annual letter to Berkshire Hathaway shareholders, between 1965 and 2018, he generated an annualised return of 20.5% per year for his investors, which is more than twice the annualised return of the S&P 500 index over that investment horizon. Here, I’ll reveal one of the secrets to Buffett’s success, and explain how UK investors can apply his strategy to the FTSE 100 to build up substantial wealth.
A focus on quality
Buffett is often viewed as a ‘value’ investor as he studied under Benjamin Graham, who is referred to as the ‘father of value investing’. Buffett also likes to buy stocks when they’re ‘on sale’ and he can pick them up with a ‘margin of safety’. However, take a closer look at Buffett’s approach and you’ll find that he also has a strong focus on quality. Valuation definitely isn’t the be-all and end-all for him. “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price,” he says.
In terms of quality attributes, there are a number of things that he looks for in a potential investment. First, he wants to see a competitive advantage such as a strong brand name. This will help stop rivals from stealing market share and eroding profits. Second, he looks for companies that are highly profitable. Here, he analyses the return on equity (ROE) ratio to determine how effective management is at generating profits.
Third, he likes companies that have good track records. Most of the companies he invests in are reliable dividend payers. Finally, he always looks for financial strength. He likes companies with low levels of debt, as this makes them less vulnerable during downturns, and he also focuses on companies that are liquid and have the ability to meet their short-term obligations.
By focusing on high-quality companies with these attributes, and holding them for the long term, Buffett has generated incredible returns for his investors.
A Warren Buffett approach to the FTSE 100
The good news for UK investors is that this kind of investment strategy is not so hard to replicate with UK stocks. In the FTSE 100, there are plenty of companies that could be considered ‘high-quality.’
A good example, in my view, is online broker Hargreaves Lansdown. Not only does it have a dominant market position in the UK investment space, which gives it a competitive advantage, but it’s also an extremely profitable (high ROE) company with a good dividend track record and a strong balance sheet. A favourite of ‘Britain’s Warren Buffett’ Nick Train, Hargreaves has delivered a return of 90% plus dividends over the last five years, smashing the return from the FTSE 100.
Ultimately, the takeaway from Buffett’s strategy is that investing doesn’t need to be complicated. A simple long-term investment strategy that focuses on high-quality FTSE 100 companies could help you build up serious wealth.
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Edward Sheldon owns shares in Hargreaves Lansdown. The Motley Fool UK has recommended Hargreaves Lansdown. 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.