DIY Investor Diary: how I apply Warren Buffett tips to fund investing

In the first article of a new series, a DIY investor explains how swotting up on Warren Buffett and learning about the long-term power of smaller companies helped him to assemble his fund portfolio. 

In our new DIY Investor Diary series, we speak to interactive investor customers to find out how they invest in funds and investment trusts, what their goals and objectives are, current issues and concerns regarding their portfolio, and what they’ve learned along the way. The premise is to try and provide inspiration to other investors, and we would love to hear from more people who would like to be involved. We do not require those willing to be featured to be named. If you are interested, please email our collectives editor Kyle Caldwell directly at kyle.caldwell@ii.co.uk

Swotting up to learn how history's most successful investors made their fortunes is a great way for DIY investors to pick up the tips and tricks of the trade.

This is exactly what the first DIY investor to be profiled in our new monthly series did when he came across Warren Buffett. The investor, who works for a financial education charity and is in his early 50s, read up on the investment principles of Buffett, as well as the Sage of Omaha’s tutor Benjamin Graham.

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There are various attributes that Buffett looks for, but his basic approach is to sniff out companies he thinks can consistently increase their intrinsic value and sustain a high return on equity over the long term. Crucially, Buffett has a beady eye on valuations, as he does not want to overpay for a company. 

To find companies well-placed to keep competitors at arm's length in the decades to come, Buffett looks for businesses with strong economic “moats”. The quality growth names to which he is naturally drawn possess some sort of competitive edge, such as being armed with intangible assets or selling a product or service bought repeatedly by a loyal customer base. Such companies are typically price-makers, as they are able to dictate what they charge for their product. In a high inflationary environment, like now, this quality becomes even more attractive.

The DIY investor, who is male, wanted to benefit from Buffett’s approach, so put his money into Buffett’s firm Berkshire Hathaway (NYSE:BRK.B). Over the years, he attended a couple of annual general meetings (AGMs) to soak up his wisdom in person.

He invested in Berkshire Hathaway for several years until 2010 when Terry Smith launched his Fundsmith Equity fund.

Smith invests in well-established high quality companies with strong competitive advantages. His stance is that he does “not seek to find tomorrow’s winners – rather, to invest in companies that have already won”. The portfolio has 26 holdings, with Microsoft (NASDAQ:MSFT), L'Oreal (EURONEXT:OR), and Visa (NYSE:V) among the top 10 holdings.

“Terry Smith builds on Buffett’s principles, and the way he invests resonates with what I believe,” our DIY investor says.

“The way I saw it, I would rather a spread of shares [Fundsmith Equity typically holds fewer than 30 companies] than just exposure to one company, Berkshire Hathaway. In addition, there’s less exchange rate risk as Fundsmith Equity is priced in pounds.”

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The DIY investor still holds Fundsmith Equity today. It is a position he's kept adding to, and he has not taken any profits. Since launch, the fund is up 519% versus 195% for the average global fund.

“Terry Smith is a rare example of a fund manager articulating his investment approach in a credible and robust way. He is very true to the strategy, and doesn’t spin a narrative.

“Hopefully, he will continue running the fund for a long time to come, but there’s also a strong team, with Julian Robins a potential successor.”

The DIY investor today has 40% of his overall investments in Fundsmith Equity, and the remaining 60% in UK smaller company funds and investment trusts. Regarding the latter, he says he wished he knew about investment trusts earlier, due to the various bells and whistles they have, which private investors can use to their advantage.

One of the main differences is that investment trusts have a fixed pool of assets that do not fluctuate with investor demand. In contrast, funds – unit trusts or OEICS – are required to sell assets to meet investor redemptions.

Having a fixed pool of assets is particularly advantageous for specialist investment trusts holding assets that cannot be easily or swiftly bought and sold, such as property, private equity or very small companies. Managers don't have to sell their holdings to release money to investors looking to liquidate their investments when markets dip; instead investors sell their shares on the stock market and the share price takes the strain.

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Due to this, our DIY investor prefers investment trusts for smaller company exposure. Among his holdings are JPMorgan UK Smaller Companies (LSE:JMI), BlackRock Smaller Companies (LSE:BRSC), Henderson Smaller Companies (LSE:HSL) and Invesco Perpetual UK Smaller (LSE:IPU).

His interest in smaller companies was piqued by long-term data showing how they have delivered higher returns compared to larger companies over the long term. Research by the London Business School found that £1 invested in 1955 in UK smaller companies would have grown to £7,933 by the end of 2020. In contrast, £1 invested in UK large companies over that 65-year period would have grown to £1,054.

Given that smaller companies have been out of favour for the past 18 months or so, now presents an opportunity to put into practice Buffett’s ‘buy low’ philosophy.

Our DIY investor points out: “I have time on my side, so I am prepared to patiently wait for smaller companies to recover. In the meantime, it is often a good time to buy when something is out of favour.

“When I am looking at smaller company options, I am looking to gain an understanding of the nuances of how the fund manager invests. My preferred way to invest in this area is investment trusts, as the structure lends itself to it given the fund manager won’t be a forced seller.”

Caption: Warren Buffett and Terry Smith

In his early 50s, the DIY investor is aiming to continue growing his investments for the foreseeable future. However, when the time comes to start drawing down on his pot, he won’t be switching his investments from growth to income. Instead, he says he will sell down fund units when he wants to spend some of the capital growth achieved over the years.

“I completely agree with Terry Smith on this – I don’t get why people focus so much on income. At the end of the day your pension fund – such as a self-invested personal pension (SIPP) – is meant to be run down at retirement, so sell a bit of your investments when needed.”

Smith’s stance on income is that while reinvested dividend income may be a crucial element of long-term returns, it does not follow that investment styles focused on maximising dividend income will deliver more growth.

The DIY investor’s portfolio does not contain any passively managed strategies – index funds and exchange-traded funds (ETFs). He points out that Buffett’s stance on the active versus passive fund debate is one that he agrees with. Buffett has said that for most people they are better off opting for a low-cost index fund.

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However, with his own investments, our DIY investor prefers active funds, which have the ability to outperform an index.

He said: “I agree that passive is a good option for many as a core holding, but I am prepared to take the risk of picking active funds in the hope of outperformance. There’s a lot of fund managers who have rubbish track records picking stocks, but there’s also a lot of dross in a passive fund.”

He has no plans to hang up his boots. Our DIY investor points out that investing is one of his hobbies and that he will continue with it while he is mentally active, and that a key motivation for investing is financial independence. He notes that investing “creates more options for myself. It's money not for the sake of it, but it gives options for myself or to help others.”  

Lessons learned over the years

Our DIY investor’s top tip is the earlier you invest, the better. This is to benefit from the power of compound interest, achieved through investing for the long term.

In a nutshell, compound interest refers to the way investment returns themselves generate gains. For instance, if you invest £1,000 into a fund returning 5% over one year, you'll earn £50. Assuming that you don't withdraw any money, the next year you'll earn 5% on £1,050, which is £52.50. This doesn't sound like much of an uplift, but as each year passes, the compounding effect multiplies.

He also stresses the importance of fees, including platform charges, which is one of the only things that private investors can control.

Our DIY investor says that investing for the long term and keeping your emotions in check are other ways to increase your chances of investment success.

He also names a couple of other very useful tips: “Write down the rationale for every purchase and sale. This particularly helps when markets are jittery. Also remember that shares don’t have emotions, but humans do. This is important to remember regarding losses.”

At such times, he says, rather than panic-selling investors should take a step back and come to a rational decision, one that is not based on emotion. “Challenge yourself on what you believe and what you disbelieve – letting go of a view is difficult for most of us,” he says.

As history shows, for those willing to take a long-term perspective sharp dips end up being a mere footnote in the grand scheme of things. At times of stock market turbulence, it is worth remembering that volatility is part of the deal of investing in equities. It is the price investors pay for the fact that, over the long run, putting money into shares rather than leaving it in cash will yield greater rewards.