Warren Buffett has a secret: His portfolio delivers gigantic cash flow which he reinvests into other long-term gigantic cash flow yields that compound billions at 20% per year or higher, year after year after year.
The power of compounding yields is often discussed but rarely understood. For example, every fund manager out there knows about compounding but almost none use an investment strategy which has compounding as an integral part of the strategy and therefore, almost no fund managers beat the market rates of return much less achieve 20% or higher annual cash flow. So how does Buffett do it and why can't the other Big Guys follow his obviously successful lead?
The first reason is that Buffett has an iron grip on his capital and fund managers don't. Buffett doesn't have to deal with investors pulling their capital out of his fund because they don't like the short term, quarterly results compared to other fund managers. This is why Buffett dumped the Buffett Partnership in the 60's and created Berkshire Hathaway as his investment vehicle. Limited partners and investors in mutual funds can take their money out and force a fund manager to sell off 'long-term' investments at bad prices. Investors in Berkshire can only drive down the price of the stock when they sell. They can't take the capital of the company like partners and fund investors can. With total control of his capital, Buffett can think long-term.
You and I have the same exact ability. We don't have to answer to investors whose emotional reactions to market swings can screw up a long-term strategy. We can do what Buffett does – buy with a focus on a ten-year time span.
The second reason is that Buffett focuses on cash yield. Fund managers focus on stock price. Cash yield is the flow of cash from the investment to the investment owner. Buffett owns companies through Berkshire so that the excess cash flow of the investments can flow up to Berkshire without taxation. Fund managers aren't in the investments for cash flow. They are looking to increasing prices for their returns. The difference is amazing in terms of compounding growth rates.
Let's say a Buffett investment produces a 4% cash yield from excess cash flow after he makes the investment and that the company is growing earnings at 10% a year. What that means is that the cash yield is growing at 10% per year. In 10 years the cash yield will be 10% on the original investment. However, the actual cash yield is much higher than that because each year the cash flow to Buffett returns a small part of his original investment, meaning that 10 years later he has received back a big chunk of his original investment and his actual basis (remaining investment) in the business is much less than the original.
This is what actually happens: Year 1 he gets back 4.4%. Year 2 he gets back 5%. Year 3 he gets back 5.5% and so on. By the 10th year, this business will have returned about 70% of the original investment and it will have grown its cash yield on the remaining investment capital to a return of almost 35% per year and still growing.
Rule #1 investors do the same thing Buffett does. We buy with a high yield because the company is on sale. We take the dividend and reinvest it elsewhere at the same high yield and the recovery of capital from the dividend reduces our basis and increases our cash on cash yield.
This is the biggest secret to getting rich that I know of. Buy a wonderful company on sale. Reduce the basis with the dividend. In ten years achieve yields of 20% to 35% per year on remaining basis. Reinvest the returned capital in other, similar investments year by year. Eventually your entire portfolio will have a yield of 20% per year and every year that yield will grow far in excess of inflation and you can sit on a beach someplace doing whatever you want forever.
Now go play.