Possibly the most successful investor of all time, Warren Buffett is an inspiration for millions around the world. I believe his strategy for finding the best stocks is a good way to grow my own portfolio. Taking an ultra long-term view, one of his main tenets is compounding growth. This is the constant rate of return over a given period of time. He also seeks the stocks that earn most for their shareholders. I’ll unpack these techniques and apply them to two FTSE AIM growth stocks that fit the bill. Let’s take a closer look.
Warren Buffett’s compounding growth
In 1999, a shareholder asked Buffett how he achieved such staggering wealth. He said, “Start early … I started building this little snowball at the top of a very long hill. The trick to have a very long hill is either starting very young or living to be very old.” For Warren Buffett, therefore, time is the greatest barrier to amassing a fortune.
This is because we can usually only see the power of compounding growth over a relatively long period. It might be surprising, but Buffett acquired 99% of his $100bn after the age of 50 years old.
So, how do we go about calculating compounding growth? It may be achieved through this formula:
(Vfinal/Vbegin)1/t − 1, where V = value and t = time
Breaking this down, we may have a set of data like earnings per share (EPS), that begins in 2017 at 1.3p and ends in 2021 at 4.5p. The ‘final value’ is 4.5p and the ‘begin value’ in 1.3p. Dividing these gives us 3.46. The time period is five years, so t = 5. We therefore calculate 3.46(1/5), which equals 1.28. Finally, 1.28 − 1 = 0.28, so our compounding annual growth rate of this set of EPS is 28%.
Some of Warren Buffett’s biggest holdings, like McDonald’s, exhibit consistent growth in this way. It is therefore a key part of his investing strategy.
2 FTSE AIM stocks that fit the bill
I’ve found two FTSE AIM shares that have consistent earnings growth based on Warren Buffett’s technique. The first, Atalaya Mining (LSE: ATYM), is a copper mining company operating in Spain. Using the formula above, I have calculated its earnings growth over the five calendar years from 2016 to 2020 as 14.4%.
What’s more, the company is using the profits that it keeps, the ‘retained earnings’, for further expansion. For instance, it is building a new industrial plant to create more efficient mining of copper and reduce its carbon footprint. Just last month, however, it stated that the budget may need to be revised if gas prices stay as high as they are.
The second stock is dotDigital Group (LSE: DOTD), a software marketing automation platform. As per the calculation, for the period between the years ended 30 June 2017 and 2021, this company boasts a compounding annual growth rate of 10.8% for its EPS. Again, this is strong, consistent, and adheres to Warren Buffett’s principle.
Although Canaccord recently downgraded the shares based on apparent “slowing momentum”, retained earnings are being directed towards research and development. This has resulted in a 22% increase in revenue from better product functionality, as recorded in a trading update for the six months to 31 December 2021.
Strong earnings growth and the competent deployment of retained earnings are important to Warren Buffett. These techniques give me a good chance of obtaining consistent growth over the long term. I will be buying both Atalaya Mining and dotDigital now.
Andrew Woods has no position in any of the shares mentioned. The Motley Fool UK has recommended dotDigital Group. 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.
