How Warren Buffett achieved returns of 20% a year (and how investors can copy him)
With Warren Buffett announcing that heâll no longer be writing Berkshire Hathawayâs annual report, thereâs been a lot of focus on his amazing long-term track record recently. It really is quite astonishing â since the mid-1960s he’s generated a return of around 20% per year for his investors.
Thatâs nearly twice the annual return of the S&P 500 over that time and much higher than the returns that most other investment managers have delivered in recent decades. It begs the question â how’s he done it?
A focus on quality and compounding
Iâve spent a lot of time studying Buffett’s investmentâs strategy. And the way I see it, there are three key things that the investing guru has done differently to most other investors.
First, he’s focused on high-quality businesses. Originally, he was a value investor, seeking out extremely cheap âcigar buttâ companies that no one else wanted to invest in. However, over time, he pivoted to a ‘quality’ approach — companies with dominant market positions, wide economic moats, strong balance sheets, and high levels of profitability.
As part of this quality strategy, heâd look for companies that were consistently able to generate a high return on equity (ROE) and continually reinvest their profits for future growth.
This is âcompounding 101′. If a business is highly profitable and can reinvest a large chunk of its earnings consistently, itâs likely to get much bigger over the long run.
âThe primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed and not the achievement of consistent gains in earnings per share.â
Warren Buffett in the 1970s
He held stocks for decades
That brings me to my next observation. Buffett has often held stocks for decades, allowing the underlying companies to compound their earnings significantly.
A great example here is Coca-Cola (NYSE: KO). He first invested in the beverages firm all the way back in 1988.
This is a high-quality company with a strong brand and a dominant market position. Itâs also very profitable â over the last five years its ROE has averaged about 43%.
Add the high ROE with Buffettâs multi-decade investment horizon, and we get spectacular results. I calculate that Buffett has made over 20 times his money on this stock and thatâs not including dividends!
An unorthodox approach to portfolio construction
Thereâs one more thing I need to mention though and this is that Buffett has always had an unusual approach to portfolio construction. In short, he hasnât been afraid to have huge positions in certain stocks.
We can see this with Coca-Cola today. Currently, itâs about 9% of his portfolio.
Ultimately, what heâs done is ride his winners for the long run. Instead of selling out after a share price doubled or tripled, heâs held on for the big gains.
Most investors donât or canât do this. For example, compliance departments at investment management firms generally donât allow fund managers to have huge positions in individual stocks (one reason why many managers underperform).
Now, Iâm not saying that investors should consider rushing out and loading up on Coca-Cola shares today. They look a little expensive right now and there are also some risks around consumer spending.
But by following Buffettâs approach, investors may be able to improve their long-term returns significantly.
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Edward Sheldon has positions in Coca-Cola Company. The Motley Fool UK has no position in any of the shares mentioned. 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.
