The Home Run Stocks Buffett Can't Buy

Warren Buffett gets opportunities the rest of us don't. He's the name-brand investor companies go to when they need cash or a smidge of reputation in a hurry.

I have previously chronicled the crazy-sweet terms Goldman Sachs and General Electric gave Buffett during the heart of the financial crisis. How crazy-sweet? They begged Buffett -- technically his company, Berkshire Hathaway -- to lend them money at a guaranteed 10% plus equity upside.

But before you get too jealous, know that this wasn't always the case.

How Buffett made his opportunities
Let me take you back to a time when Buffett wasn't worth 11 figures. Back to a time when he had only five figures to work with.

In his 20s, Buffett's eventual avalanche was just a snowball. All his name could get him was a dinner reservation ... if he called ahead.

So he had to work to find deals to invest in -- deals that would form the basis of his fortune. He sought out the master investors of his time, including his hero Benjamin Graham, and learned everything they would teach him.

But more than anything, he did the legwork that others weren't willing to do. In this time before the Internet, he'd physically go to Moody's and Standard & Poor's to read old reports, to the Securities and Exchange Commission to read filings, and to company headquarters to talk with management.

His persistence was rewarded handsomely, particularly in tiny, underfollowed companies. In Buffett's own words: "I would pore through volumes of businesses, and I'd find one or two ... that were just ridiculously cheap."

How cheap? In one six-year period, he grew his wealth by more than 60% a year. By age 26, he had amassed so much wealth that he considered retirement.

How Buffett lost his opportunities
Of course, he didn't retire. In the decades since, he's continued putting up incredible returns, and he's laid claim to the unofficial title of greatest investor ever.

But with all this wealth comes a problem.

That problem is exemplified by Buffett's recent purchase of the Burlington Northern Santa Fe railroad -- which he admits wasn't a particular bargain.

The man who has absolutely throttled the market for more than five decades now says, "Reasonable return is good enough. ... I mean, 50 years ago, I was looking for spectacular returns, but I can't -- I can't get them."

Why the surrender? One word: size.

Berkshire Hathaway is roughly the size of Wal-Mart now. Buffett's empire has grown so large that the small multibaggers he used to stalk no longer make a dent in his portfolio's returns.

For Buffett, analyzing and buying a small-cap stock has roughly the same cost benefit as us walking a mile to pick up a quarter. Instead, he's stuck stalking elephants like Burlington Northern, which was roughly the size of eBay.

Could he still do it today?
When Buffett could stalk mosquitoes instead of elephants, his returns were consistently monstrous. That was a long, long time ago, though. Could he still do it today?

He thinks so. He says, "It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that."

Wow. Now, before we get carried away, that's the greatest investor in the world taking on the market with no restrictions.

The takeaway for us mere mortals is that there's more opportunity for outsized returns in small-cap stocks than there is in larger-cap stocks.

Just like Buffett
It's nice to know we have one advantage over Buffett.

To take advantage, we have to do the same type of work Buffett did back in his heyday -- study the master investors; research the company, its competitors, and its management thoroughly; and dig into financial statements to find strong balance sheets, strong operations, and large margins of safety.

But where to start? To get a list of candidates to start you off, I screened for small companies with low levels of debt and high returns on equity (which gets at strong balance sheets and strong operations, respectively):

Company

Market Cap (in millions)

Debt/Capital

Return on Equity

Cooper Tire & Rubber (NYSE: CTB  )

$1,287

47.9%

33.2%

Medifast (NYSE: MED  )

$380

8.6%

31.7%

Suburban Propane Partners LP (NYSE: SPH  )

$1,909

45.9%

31.3%

Cal-Maine Foods (Nasdaq: CALM  )

$653

23.4%

21.5%

Bio-Reference Laboratories (Nasdaq: BRLI  )

$611

22.4%

19.2%

RF Micro Devices (Nasdaq: RFMD  )

$1,815

34.6%

18.8%

Smith & Wesson (Nasdaq: SWHC  )

$236

32.7%

17.4%

Source: Capital IQ, a division of Standard & Poor's.

Among the things screening can't tell you is the quality of management, the competitive pressures the company faces, and the sustainability of earnings. After all this, the price also has to be right for that key margin-of-safety element.

If you'd like some help constructing your own portfolio -- including the small-cap plays of Buffett's younger years and the large-cap plays of the current Buffett -- check out our Million Dollar Portfolio service. Our analysts construct a real-money portfolio of the "best of the best" of the Motley Fool's newsletters. Click here to get started.

This article was originally published Dec. 24, 2009, as "The Home Run Stock Buffett Can't Buy." It has been updated.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Anand Chokkavelu owns shares of Berkshire Hathaway. Berkshire Hathaway, Moody's, and Wal-Mart Stores are Motley Fool Inside Value choices. Berkshire Hathaway, eBay, and Moody's are Motley Fool Stock Advisor selections. Motley Fool Options has recommended a bull call spread position on eBay and writing covered calls on Moody's. The Fool owns shares of Berkshire Hathaway, Bio-Reference Laboratories, Cal-Maine Foods, and Wal-Mart Stores. The Motley Fool has a disclosure policy.


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