JEPI - Warren Buffett's Wealth-Building Formula: Consider VIG Instead Of Berkshire Hathaway

2023-12-21 07:15:00 ET

Summary

• Warren Buffett's wealth-building formula has delivered phenomenal long-term results.
• We examine several Buffett quotes that encapsulate his wealth-building formula.
• We also look at why Vanguard Dividend Appreciation Index Fund ETF could be a better option than Berkshire Hathaway for investors looking to implement Buffett's wealth-building formula over the long-term.

Legendary investor Warren Buffett of Berkshire Hathaway ( BRK.A )( BRK.B ) has crushed the S&P 500 ( SPY ) over the long-term and built a vast fortune through astute investments. His approach, characterized by long-term value investing and often buying stocks demonstrating consistent dividend growth, is largely responsible for his tremendous success. This article delves into the core principles underpinning Warren Buffett's wealth-building formula, a strategy that has stood the test of time in generating sustainable wealth. In particular, we will examine Warren Buffett's wealth-building formula and explain why the Vanguard Dividend Appreciation Index Fund ETF ( VIG ) is a great vehicle for applying that formula to one's portfolio.

Warren Buffett's Wealth-Building Formula

The foundation of Warren Buffett's investment philosophy can be summed up in two of his quotes:

1. If you don't find a way to make money while you sleep, you will work until you die.

2. Life is like a snowball, all you need is wet snow and a really long hill.

The first quote highlights the significance of passive income in building wealth. Buffett's strategy centers around this principle, stressing the importance of accumulating investments that generate income even when you are not working.

Buffett's second quote provides a metaphor to describe the principle of passive income combined with the power of compounding to explain how an effective passive income snowball can cause one's wealth to grow substantially over time. In this context, 'wet snow' refers to solid investment choices that have the potential to grow, while the 'long hill' represents the advantage of time. When dividends or interest are reinvested, they accumulate more assets, which in turn generate additional income. This cycle of earning and reinvesting creates a compounding effect, where the growth of an investment portfolio accelerates over time, similar to a snowball rolling down a long hill, gathering more snow and momentum as it goes.

The passive income snowball works by taking the initial dividends or interest earned and reinvesting them to purchase more income-generating assets. Over time, as these assets grow and generate more income, the capacity to reinvest increases, leading to even greater asset accumulation. This approach not only provides a source of income that can eventually replace active income but also offers the significant benefit of wealth growth without the need for constant active management or labor. Thus, embracing the principle of making money while you sleep through the power of the passive income snowball and then waiting patiently for time to do its work is central to replicating Warren Buffett's successful wealth-building formula. As Warren Buffett also once said :

The stock market is a device for transferring money from the impatient to the patient.

At the end of the day, it is not timing the market, but time spent in the market invested in effective compounders that will maximize long-term wealth. While it may sound simple, this is the uncomplicated yet highly effective method that Mr. Buffett has employed so effectively all of these years.

Why VIG Is A Great Vehicle For Applying Warren Buffett's Wealth-Building Formula

While some who want to follow Warren Buffett's wealth-building formula may simply wish to purchase BRK.B stock and let that compound over the long term, there are reasons why investing in a low-cost diversified dividend growth ETF may be a better option.

First and foremost, investing legend and Buffett's right-hand man Charlie Munger recently passed away and Buffett may not be far behind him. Once Charlie Munger and Warren Buffett are both gone, BRK.B stock could possibly suffer a revaluation lower as the primary brain trust that built the company's incredible track record will be gone. Moreover, there will no longer be the same assurance for investors that the company will implement the same simple, yet brilliant, investment approach with the same degree of effectiveness over the long term.

Another reason why an ETF may be a better option than BRK.B stock is that Berkshire has gotten so large that it is no longer as efficient in its capital allocation due to the fact that it must enter and exit positions more gradually today (thereby not securing optimal pricing for stock purchases) and it is also increasingly restricted to more efficiently valued larger companies for new acquisitions.

A third reason to prefer an ETF over BRK.B stock is that dividend growth ETFs typically own a diversified portfolio of dividend-paying stocks from various sectors and industries, thereby reducing risk compared to holding BRK.B's more concentrated positions. This diversification ensures exposure to "wet snow" (i.e., solid investment choices) across different sectors while reducing the risk of a significant misallocation of capital, particularly by one of Berkshire's portfolio managers not named Buffett.

Fourth, there are times when BRK.B stock is overvalued by the market and even Buffett himself would not buy the stock. As a result, if you are constantly investing in BRK.B stock as your sole long-term wealth compounder, there is a good chance that you will be significantly overpaying at times when making new investments. In contrast, ETFs are often so diversified that on the net you end up always paying a reasonably fair price relative to current market consensus estimates. This takes out a lot of the guesswork of investing and makes this approach a simpler path to long-term wealth compounding.

As a result, investors who want to follow Warren Buffett's formula for building wealth may find the VIG ETF to be an attractive option because its structure and strategy align with his investment philosophy of combining passive income generation and capital appreciation, resulting in exponential compounding of wealth over long periods of time.

1. Sector Holdings and Diversification

VIG takes a balanced and diversified approach to sector allocation. The fund’s sector holdings are weighted towards Technology (23.53%), Financials (18.73%), Health Care (15.08%), Industrials (12.79%), and Consumer Defensive (11.73%), with smaller allocations in Consumer Cyclical (7.11%), Basic Material (4.20%), Energy (2.95%), Utilities (2.64%), and Communication (1.22%). This diversification across sectors means that the fund is likely to generate a relatively stable performance across a variety of market conditions.

2. Top 10 Holdings

Delving into VIG's top 10 holdings provides further confidence in its durability as a long-term wealth compounder as we find a plethora of very strong companies that are consistent with Buffett’s preference for buying 'wonderful businesses' with a strong competitive advantage and a track record of dividend growth. These include:

1. Microsoft Corp ( MSFT ) - 5.53%
2. Apple Inc ( AAPL ) - 4.56% (Buffett's largest single holding by far)
3. UnitedHealth Group Inc ( UNH ) - 3.50%
4. JPMorgan Chase & Co ( JPM ) - 3.10%
5. Exxon Mobil Corp ( XOM ) - 2.84%
6. Visa Inc Class A ( V ) - 2.70%
7. Broadcom Inc ( AVGO ) - 2.69%
8. Johnson & Johnson ( JNJ ) - 2.55%
9. Procter & Gamble Co ( PG ) - 2.49%
10. Mastercard Inc Class A ( MA ) - 2.37%

These top holdings, which account for 32.33% of the fund's assets, provide robust dividend growth year after year and have the potential for - and impressive track records of - generating capital appreciation. Moreover, heavyweights like Microsoft and Apple give VIG exposure to growth-oriented technology giants which balances the portfolio’s income generation with long-term growth prospects.

3. Dividend Growth Track Record

VIG has a proven track record of increasing dividends to shareholders over time given its strict criteria of only including companies that have raised their dividends for at least ten consecutive years. Although it may not have had the highest dividend growth rate compared to its competitors during certain periods, VIG has still put up strong numbers, with a 9.91% dividend growth rate over the past twelve months, a 12.33% dividend CAGR over the past three years, and a 9.52% dividend CAGR over the past half-decade.

This high rate of dividend growth over a prolonged period of time presents a powerful wealth-compounding proposition for investors. This is because when a stock grows its dividend payout each year and these dividends are reinvested to purchase additional shares that in turn, generate their own dividends, a virtuous cycle is formed. This cycle then leads to an exponential increase in the number of shares owned and the total dividend income received over time as the dividend grows from both the number of shares increasing and the dividends per share increase each year. This compounding effect becomes even more powerful and exponential as the investment time horizon increases.

This impressive compounding process is evidenced by its long-term solid total return performance, even outperforming the Dividend Aristocrats ( NOBL ) over that period of time:

As a result, investors can have confidence that VIG will not only grow dividends at a pace that significantly exceeds inflation but will very likely be generating strong capital appreciation to go along with its passive income growth over the course of many years.

4. Minimal Fees

Another reason to favor VIG as a vehicle for long-term wealth compounding is due to its remarkably low expense ratio of just 0.06%. This minuscule expense ratio offers a significant advantage over funds with higher fees, such as the JPMorgan Equity Premium Income ETF ( JEPI ), which carries a 0.35% expense ratio because - over the long term - the lower expense ratio of VIG translates into higher net returns for investors, as less of their investment is eroded by management fees. This difference becomes increasingly impactful over time due to the compounding effect of these savings. As Warren Buffett himself stated once :

Performance comes, performance goes. Fees never falter.

Investor Takeaway

Warren Buffett's wealth-building formula is centered around several core principles, including long-term value investing, passive income generation, and the power of compounding.

Investors can easily implement these principles through a proven dividend growth ETF such as VIG. The fund's strategic focus on diversification across various sectors, inclusion of companies with a strong track record of dividend growth, and minimal fees aligns well with Buffett's investment philosophy. VIG's holdings include significant investments in the high-growth technology and high-income financial sectors, underscoring its potential for a continued attractive combination of growth and dividend income. Moreover, its low expense ratio further enhances its attractiveness as a vehicle for long-term wealth compounding and falls directly in line with Buffett's emphasis on the importance of keeping fees to a bare minimum.

Investing in BRK.B has been the obvious and most effective choice thus far for investors wanting relatively passive exposure to Buffett's wealth-building methodology. However, moving forward, Buffett disciples who do not want to pick individual stocks may prefer VIG over BRK.B due to concerns about Berkshire Hathaway's post-Munger and Buffett leadership and capital allocation efficiency, the superior diversification, passive income, and risk reduction benefits offered by dividend growth ETFs, and the potential overvaluation of BRK.B.

For further details see: