NEWSLETTER
Image source: The Motley Fool
There are many reasons why billionaire investor Warren Buffett has done so well.
He has invested in large companies. It has been active at times when the market was seriously undervalued. He had access to other people's capital from an early stage of his long career.
But one simple move, which I can copy in my own investments, has undoubtedly made the Sage of Omaha billions.
Double the success
That movement is known as capitalization.
In other words, when Warren Buffett earns juicy dividends from a stock he owns, he doesn't throw them into a drag at the races, or even pay dividends to his own company's shareholders. Instead, you reinvest them.
Buffett has even gone so far as to say: “my life has been a product of compound interest“.
His late partner Charlie Munger was a big fan. He said: “The elementary mathematics of compound interest is one of the most important models that exist on earth.”.
How compounding helps build fortunes
Remember when you were a kid trying to fold a piece of paper, then folding it again and again, only to discover after about seven times that it simply couldn't be folded again?
The reason was that it was too thick. Compounding works on a similar principle, but without a necessary endpoint.
It is much more difficult to buy a stock that doubles in value than it is to double the height of a sheet of paper by folding it. But let's imagine that I can increase the value of my portfolio by 10% per year.
After a year, every £100 would be worth £110. But next year, 10% would mean an increase of £11. The following year, it would be 10% of £121: £12.10. Notice how extra money itself makes extra money? That is the essence of capitalization.
Warren Buffett has been investing for about 83 years. If I built up £100 in my 10% stocks and shares ISA over 83 years, without investing any new funds, the ISA would be worth it. £388,783! Yes, you read that right.
Find stocks that produce great returns
In some ways, it's easier for me as a small private investor to find stocks that produce big returns than it is for Buffett. Your portfolio is so large that few investments can really make a difference.
One that has occurred in recent years is Apple (NASDAQ:AAPL). Buffett has been selling shares heavily over the past few months, but it remains a key part of his portfolio.
Let me use Apple to illustrate some of the characteristics I would look for when searching for a stock that I expect can grow at a long-term compound growth rate of 10% annually (the tech giant is up 274% over the past five years, even without having dividends into account).
It has a large and resilient target market. Apple has competitive advantages that give it what Warren Buffett calls a “pit”, from a strong brand to a unique ecosystem of products and services.
A key risk is lower-cost competition, and Apple's revenue actually fell last year. But I still think it's a great business. I have no plans to buy its shares simply because I think its P/E ratio of 35 is too high.
