How to Apply Warren Buffett’s Investing Strategy: Lessons from the Master

In the world of investing, there are few names more revered than Warren Buffett. The Oracle of Omaha has become a household name for his legendary investment success, and his annual letters to shareholders are closely watched by investors around the world. In his most recent letter, Buffett reflected on the staggering long-term growth in dividends and share prices at a handful of his company holdings.

If you’re looking to build your own investment portfolio with a focus on quality businesses, you might be wondering how to replicate Buffett’s success. While there’s no guaranteed formula for success in the stock market, there are certainly lessons to be learned from Buffett’s approach. And thankfully, you don’t need to be a billionaire to start investing like him.

Investing in quality businesses

One of the core tenets of Buffett’s investing philosophy is to invest in businesses, not stocks. Buffett aims to make meaningful investments in businesses with long-lasting favorable economic characteristics and trustworthy managers. As he has said, “Charlie and I are not stock-pickers; we are business-pickers.”

This approach means looking beyond short-term stock price movements and focusing on the long-term prospects of the underlying business. Buffett believes that by investing in high-quality businesses with strong fundamentals, investors can build wealth over time through the power of compounding.

Lessons from Buffett’s latest letter

Buffett’s annual letters to shareholders are a goldmine of investing wisdom. In this year’s letter, he focused on simple lessons about why Berkshire Hathaway’s approach has worked so well and what future investors can learn from it.

One lesson is that nothing is certain, and luck is important. Despite his focus on picking businesses, Buffett owns his mistakes and acknowledges that some of his capital-allocation decisions have been no better than so-so. In some cases, bad moves have been rescued by large doses of luck.

Another lesson is that you only need to make a few good decisions to transform your wealth. Buffett’s experience shows how a few big winners can have a huge impact on an investment portfolio over time. For example, Berkshire spent $1.3 billion buying shares in Coca-Cola in the seven years up to 1994. Last year, the dividend paid on those shares was $704 million, and Coca-Cola was, and remains, 5% of Berkshire’s net worth.

Investing in high-quality businesses

So how can you apply these lessons to your own investing? One way is to focus on companies with high profitability indicators over time. In a recent stock screen inspired by Buffett’s approach, we looked for companies with:

  • High five-year average free cash flow margins (greater than 10%)
  • High five-year average return on capital employed (ROCE) (greater than 15%)
  • High five-year average operating margins (greater than 15%)

To narrow down the list further, we also looked for companies with a track record of paying dividends for more than 10 years and growing dividend payouts for more than nine years.

Some of the results of this screen include companies like Spirax-Sarco Engineering, Halma, and Impax Asset Management Group. While many of these companies trade on forecast price-earnings (PE) ratios above 20x, the quality of the underlying businesses stands out. Companies with high average returns, operating margins, and free cash flow margins are particularly appealing in inflationary environments, where profits are at risk of being eroded.

In terms of dividends, it’s important to note that the yields on these stocks are generally unremarkable. However, for Buffett-style investing, the most important factor is that the company is allocating cash as effectively as possible – either to growth, paying dividends, or buying back shares.

Lessons for investors

While investing in quality businesses might sound simple, it’s not always easy to execute.

So how can investors use these lessons to their advantage? One way is to focus on companies with high profitability indicators over time. Ben Hobson’s Buffett-themed screen includes a focus on businesses with a high five-year average free cash flow margin greater than 10%, a high five-year average return on capital employed greater than 15%, and a high five-year average operating margin greater than 15%.

But as a nod to Buffett’s recent commentary on dividends, the screen narrows the range to pick up companies with a track record of paying dividends for more than 10 years and growing dividend payouts for more than nine years. The results are interesting.

At first glance, almost all of the shares on the list trade on forecast price-earnings (PE) ratios well above 20x. The highest are steam management group Spirax-Sarco Engineering on 31x, and safety equipment specialist Halma on 29x. This is potentially expensive territory for investors to pay up for quality, although several of the shares are still way off their one-year highs.

What stands out most on the list is the quality of the companies. As a business picker, quality can be found in high average returns, with measures like return on capital and operating margins. These are particularly appealing in inflationary environments where profits are at risk of being eroded.

The asset management sector is a high-margin industry, and this is reflected in the 30-plus figures at Impax Asset Management Group and Liontrust Asset Management. Information and analytics group RELX is another high-margin firm, but even the more specialist industrial businesses on the list look solidly profitable over time.

In terms of dividends, there are clues that they are all consistent payers, although note that the yields on these stocks are generally unremarkable. That isn’t necessarily a problem for Buffett-style investing, where the most important factor is that the company is allocating cash as effectively as possible, either to growth, paying dividends, or buying back shares.

Overall, technical products company Diploma leads the list on dividends with a 31-year record of payouts, 22 of which have seen its dividend grow. But whether you are interested in Diploma or any of the other companies on the list, the lessons from Buffett remain the same: a few good choices, good luck, longevity, and an uncanny ability to weather the course over the long term are all winning traits.

Investors can benefit from focusing on the quality of the business without overpaying for its shares. Buffett’s approach has worked well over the years and is worth bearing in mind, especially in uncertain times. As always, he puts it better than anyone else: “We will try to profit by correctly predicting future changes in the society, the economy, and the companies in which we have invested. But, in doing so, we will make no attempt to micromanage these companies. That means we will not enter the management of them, but we will help them in any way we can, consistent with the best interests of our shareholders.”

Another important lesson from Buffett is his focus on compounding returns. In order to achieve long-term wealth creation, it is not enough to simply make good investments; one must also reinvest the returns in order to achieve compounding growth. This means that instead of taking profits and spending them, investors should reinvest them back into the same or similar assets in order to achieve growth over time. This is something that Buffett has famously done with his investments, and it has allowed him to achieve incredible returns over the course of his career.

If you’re looking to apply Buffett’s lessons to your own investing strategy, there are a few key areas to focus on. One of the most important is to invest in businesses rather than stocks. Buffett has always stressed the importance of finding businesses with strong economic moats and trustworthy managers, as opposed to simply investing in the hottest stocks of the moment. By investing in solid, well-established businesses with sustainable competitive advantages, you can increase your chances of achieving long-term success.

Another key area to focus on is compounding returns. By reinvesting your profits and allowing them to grow over time, you can achieve incredible results even with relatively modest initial investments. This is particularly true if you focus on high-quality businesses with strong growth prospects and solid fundamentals.

Finally, it’s important to remember that investing is a long-term game. While it’s tempting to try and make quick profits by jumping on the latest hot stock, this kind of short-term thinking is unlikely to lead to sustained success. Instead, focus on building a diversified portfolio of high-quality investments that can deliver steady, reliable returns over the long term.

In conclusion, Warren Buffett’s approach to investing has proven to be incredibly successful over the course of his career. By focusing on investing in businesses rather than stocks, allowing profits to compound over time, and taking a long-term view, he has achieved returns that are the envy of the investing world. While it’s unlikely that any individual investor will be able to replicate his success exactly, there are still many valuable lessons to be learned from his approach. By applying these lessons to your own investing strategy, you can increase your chances of achieving success over the long term.

A guide to building a million-pound pension pot for a comfortable retirement.

Market Meltdowns: Do They Signal Bargains or More Pain Ahead?