Billionaire investor Warren Buffett’s strategy to the inventory market is extra complicated than first seems. However whereas plenty of traders are aware of some elements of his ideology, others I feel are sometimes uncared for.

One in all these is about dividends. And the Berkshire Hathaway CEO has an vital perception for traders who personal shares of firms that distribute their money to shareholders.

Buffett on dividends

In a 2020 interview with CNBC, Buffett mentioned the next about dividends:

We don’t get wealthy on our dividends that we obtain, though we’re completely satisfied to obtain them. We get wealthy on the truth that the retained earnings are used to construct new incomes energy, repurchase shares, which will increase your possession within the firm and Berkshire has retained earnings since we began. That’s the one cause Berkshire is price much more – it’s that we retain earnings.

That is most likely my favorite Buffett quote of all time. It speaks of one thing that’s massively vital, however usually ignored by traders who give attention to dividends.

It’s pure to assume reinvesting dividends in sturdy shares with excessive yields is a good suggestion. However whereas it’s not dangerous, getting essentially the most out of the inventory market requires greater than this.

Retaining earnings

Buffett’s strategy to constructing wealth is to give attention to what firms do with the money they maintain reasonably than the earnings they distribute. That is what drives earnings development.

FTSE 100 catering agency Compass Group (LSE:CPG) is a superb instance. During the last 10 years, the agency has retained round 45% of its web earnings and reinvested in again into the enterprise.

Importantly, the corporate has managed to generate wonderful returns on the money it has retained. Outdoors the Covid-19 pandemic, returns on fairness have constantly been above 20%.

I can’t consider many locations the place traders can get a return of over 20% with out taking large dangers. And I definitely don’t see alternatives to do that by reinvesting dividends.

Constructing wealth

Meaning traders trying to comply with Buffett’s strategy to constructing wealth ought to contemplate leaving their money with the agency. It may nearly definitely use it higher than they will.

As at all times although, there are dangers to contemplate. And with Compass, a key concern in the meanwhile is the prospect of job cuts within the US, particularly within the healthcare sector. It is a key marketplace for the corporate and a decline might restrict reinvestment alternatives. And whereas the share price falling offsets this danger considerably, it doesn’t completely take away it.

On the whole nevertheless, the inventory’s an ideal illustration of Buffett’s level. So long as the agency can use its money extra effectively than traders can, it’s a greater method to construct wealth than dividend shares.

Compounding

Investing to construct wealth is extra sophisticated than simply discovering shares with excessive returns on fairness. As Buffett has famous a number of occasions, the price an investor pays is crucially vital.

That’s the massive downside with Compass shares in the meanwhile. It trades at a price-to-book (P/B) a number of of over 8, which means traders solely get round £12 in fairness for each £100 they make investments.

Consequently, I see Compass as a inventory to observe, reasonably than one to contemplate shopping for. However I’m aiming to comply with Buffett’s recommendation by discovering comparable shares buying and selling at extra engaging valuations.