The Warren Buffett method of investing is easily described. To me, it means buying shares in good businesses to hold for the long term. It means focusing on the process of compounding. And prioritising the quality of an enterprise over how cheaply the shares are valuing it. But buying the quality as cheaply as possible, often paying a fair price rather than a cheap one.
Potential exponential growth
Buffett has been compounding gains at the rate of around 20% a year, on average, for decades. And running the calculations on a compound annual growth rate of 20% reveals how overall growth is exponential. The exercise goes a long way to explaining why he’s worth billions.
My plan aims to generate a £700-a-month income from dividends. But not right away. First, my portfolio will be in the building stage. And I’ll reinvest all dividend income to help keep the process of compounding going.
And to work out how much capital is needed to generate that kind of income, the FTSE 100 index is useful. Analysts expect the index to yield about 4.1% in dividends in 2022. So I’ll assume that level of dividend return each year is achievable if I simply invest money in a low-cost index tracker fund following the Footsie.
My calculation tells me £210,000 would deliver an annual dividend income of £8,400. And that works out at £700 a month for me to use.
But getting to the £210,000 in the first place is where the Buffett method comes in. Particularly on an average salary. For example, one of the main elements of research I’d use when judging the quality of a business is whether it has the potential to grow.
Compounding within businesses
That’s because Buffett’s focus on compounding means he’s always looking for the businesses to do the heavy lifting by building on its own gains in earnings. Compounding the value of a share portfolio is one thing, but compounding taking place within a business is another.
And that’s why he holds on to the shares of what he describes as “wonderful” businesses for a long time. As their earnings grow, their dividends and share prices tend to grow to reflect the progress.
However, that doesn’t always happen because operational challenges can arrive for any company causing the business to underperform and its shareholders to lose money.
But I think the recent bear market in tech and growth stocks has thrown up some great opportunities. I’ve noticed, for example, that stocks with a high element of value have been springing into life lately, suggesting a mass investor rotation away from over-priced stocks and into those with better value.
And, to me, this is a great environment for applying the Buffett method of buying quality at a fair price.
Outcomes are not certain or guaranteed and I could even lose money, but I’m investing as much as I can every month in stocks and shares right now. And I’m aiming to compound my way to the possibility of taking £700 a month in dividend income later.
Kevin Godbold has no position in any of the shares mentioned. 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.
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