Warren Buffett is a living legend -- a self-made billionaire who has used common sense and a disciplined approach to valuation to throttle the market over the past four decades. Since 1965, Buffett has amassed 21.4% compounded annual returns, turning a $10,000 initial investment into more than $36 million today.
That's crazy.
I'll be shocked if he can keep it up.
No, I haven't been drinking
Even at the ripe age of 77, Buffett still has one of the sharpest investing minds there is. But with $40 billion in cash at his disposal, Buffett's equity investments today are primarily relegated to the realm of well-known large-cap stocks, such as Procter & Gamble (NYSE: PG), Coca-Cola (NYSE: KO), and American Express (NYSE: AXP).
While investing in these corporate titans is a fine way to preserve your capital (and buying on the cheap should help Buffett continue to beat the market), they won't get anyone 21.4% annual returns for an extended period of time. And they certainly won't approach the mythical 50% annual returns that Buffett once famously boasted he could achieve if he had less money to invest.
But don't take my word for it. Buffett said the exact same thing at Berkshire Hathaway's 2007 shareholder meeting:
If I were working with a very small sum ... I'd be doing almost entirely different things than I do. Your universe expands -- there are thousands of times as many options if you're investing $10,000 rather than $100 billion, other than buying entire businesses. You can earn very high returns with very small amounts of money. Everyone can't do it, but if you know what you're doing, you can do it.
Expand your universe
So where would Buffett be looking if he could? How about at small-cap stocks. After all, small-cap stocks have historically outperformed large-cap stocks -- a gap that has widened over the past 30 years:
|
Annualized Return
|
Small Caps
|
Large Caps
|
|
1926 to 2006
|
12.7%
|
10.4%
|
|
1976 to 2006
|
17.5%
|
12.8%
|
Data from Ibbotson Associates.
Buffett could, no doubt, get these returns. The problem is that small-cap investing would not make much of a difference to his portfolio. But before we get to why Buffett won't buy small caps, let's take a look at why small caps outperform in the first place.
Mr. Big
First and foremost, smaller companies have much more room to grow. With revenue of $360 billion, energy giant ExxonMobil (NYSE: XOM) likely won't be doubling that number anytime soon. Tiny energy service company Dawson Geophysical, on the other hand, has nearly tripled in two years as revenue increased just $100 million to $234 million.
Then there's the fact that Exxon is covered by 23 Wall Street analysts, while only five track Dawson. In other words, even though Dawson's potential in the energy space was plain as day two years ago (and that's why we recommended it at Motley Fool Hidden Gems), because the company was so small, none of the big Wall Street firms were even looking at it.
A little ain't enough
Why does Wall Street ignore stocks that could very well triple?
For some of the same reasons Buffett does. When you have a lot of money, even the best-performing small companies won't juice your returns. Just consider, for example, if Berkshire bought Dawson (now valued at $600 million) whole hog when it was a $300 million company. That $300 million double to date would have moved Berkshire's $73.6 billion equity portfolio just 0.4%
Investors of all sizes will agree: There's no point in researching an idea if it will provide just 0.4% potential gains.
Every rose has its thorn
Individual investors who invest dollar amounts in the thousands, however, should be scouring the markets every day for the next Dawson Geophysical. It's the only way to even approach those aforementioned 50% annual returns.
But be forewarned: Small-cap stocks are volatile. While a large cap like Nike (NYSE: NKE) has built sufficient brand equity and financial strength to weather a few fashion faux pas, a bad year can mean the end for smaller competitors such as Steve Madden (Nasdaq: SHOO) or Kenneth Cole (NYSE: KCP).
The best of both worlds
In order to be better than Buffett, you need to invest in the cream-of-the-small-cap crop -- stocks that offer great appreciation potential and, because of their compelling valuations, provide downside protection.
That's what we do at Motley Fool Hidden Gems, where we find stocks that, like Dawson two years ago, have:
- Great growth prospects.
- Dedicated management.
- A strong balance sheet.
- An undervalued stock price.
Yes, there will be volatility. Yes, some of these stocks may lose money. But the potential rewards are real, and they're spectacular. Over the past four years, for example, Hidden Gems has beaten the market by nearly 40 percentage points on average.
You can do the same -- and beat the Oracle of Omaha in the process -- as long as you make the most of your advantages as an individual investor and know what you're doing. If you'd like some help from Hidden Gems, click here to try the service free for 30 days. There is no obligation to subscribe.
Rich Greifner's fantasy football team has great growth prospects, dedicated management, and an undesirable win-loss record. Rich owns Donovan McNabb, but he does not own any of the securities mentioned in this article. Berkshire and Coca-Cola are Motley Fool Inside Value picks. Berkshire is also a Stock Advisor recommendation. The Fool has a disclosure policy.
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