In his annual letter to Berkshire Hathway (NYSE:BRK.B) shareholders, Warren Buffett described the ‘secret sauce’ that makes his investments so successful. And its a pretty simple recipe.
According to Buffett, it’s a matter of growth and time. As the businesses Berkshire owns stock in make more money, the amount they pay out to shareholders increases, causing the value of the stock to rise.
These increases are gradual in any given year. Over time, though, a number of steady increases makes for some spectacular returns.
Buffett’s investments
Buffett illustrates this through the examples of Coca-Cola and American Express. Both are companies that Berkshire owns stock in and has done for some time.
In 1994, it bought 400m shares in Coca-Cola. This generated around $75m in dividends and had a market value of $1.3bn.
Today, that investment returns dividends of around $704m per year. And as a result, its market value has increased to around $25bn.
Something similar is true of American Express. In 1995, Berkshire’s investment had a market value of $1.3bn and paid $41m in dividends.
Around 28 years later, it has a market value of $22bn. According to Buffett, this is because it now yields $302m in annual dividend income.
Importantly, none of this success has come from Berkshire reinvesting its dividends to buy more shares. All of it has come from the companies themselves.
The key to investing success is finding companies that are going to be able to grow their earnings consistently for a long time. And as Buffett says in the letter, even finding just a few can work wonders.
Stocks to buy
Figuring out which businesses will be able to reinvest their earnings and grow consistently for 30 years is challenging. But I think there are some common features of companies that meet these conditions.
First of all, they tend to be on the smaller side. Buffett has said repeatedly the main obstacle to Berkshire’s growth going forward is its size.
Smaller companies tend to have more opportunities available to them. This gives them an advantage when it comes to increasing their earnings.
Second, they tend to have strong competitive positions. This allows them to continue growing at a good rate without being disrupted by competitors.
Finding these investments isn’t straightforward, but there’s one stock in particular that stands out to me. And it has a lot of similarities with Berkshire Hathaway.
Diploma
I think that Diploma (LSE:DPLM) has a promising outlook in terms of growth. It’s a FTSE 250 company with a promising competitive position.
With a market cap of under £3.5bn, the company is less than half the size of FTSE 100 stock Halma, less than one third of the size of Aviva, and less than one quarter of the size of Tesco. Basically, it’s ‘small’ (but not a small-cap as such).
The business aims to grow by making acquisitions. And at its current size, I think it will be a long time before it runs out of meaningful opportunities.
Diploma also has a strong competitive position. It focuses on acquiring businesses that have dominant positions in small niche markets.
Its businesses therefore aren’t large enough to attract bigger competitors and are too difficult to dislodge for smaller ones. As a result, I think it could potentially emulate the success of Buffett’s investments.
