Be Better Than Buffett

Warren Buffett is a living legend -- a self-made billionaire who has used common sense and a disciplined approach to valuation to trounce the market for 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 old age of 77, Buffett remains one of the world's sharpest investing minds. But with $47 billion in cash at his disposal, he has primarily relegated his equity investments to the realm of well-known large-cap stocks, such as Wells Fargo (NYSE: WFC) and Wal-Mart (NYSE: WMT).

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), buying into such behemoths won't earn anyone 21.4% annual returns for an extended period of time. And it 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 (NYSE: BRK-A) 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 in small-cap stocks? After all, they have historically outperformed large-cap stocks -- a gap that has widened over the past 30 years:

Undoubtedly, Buffett could get these returns. Unfortunately, small-cap investing would scarcely budge his portfolio. But before we get to why Buffett won't buy small caps, let's look at why small caps outperform in the first place.

Massive potential returns
First and foremost, smaller companies have much more room to grow. With annual revenue of nearly $200 billion, energy giant Total SA (NYSE: TOT) likely won't be doubling that number anytime soon. Tiny energy-services company Dawson Geophysical, on the other hand, has doubled its revenue in the past two years, and its stock price has followed suit.

On top of that, a mere five Wall Street analysts follow Dawson. In other words, even though Dawson's potential in the energy space was plain as day two years ago (that's why we recommended it at Motley Fool Hidden Gems), the company's small size meant that 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 double?

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 had bought Dawson (now valued around $470 million) whole-hog when it was a $235 million company. That $235 million double to date would have moved Berkshire's $77.8 billion equity portfolio just 0.3%.

Investors of all sizes will agree: There's no point in researching an idea if it will provide just 0.3% potential gains.

Every rose has its thorn
Individuals 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. Tiny enterprise-security concern Secure Computing (Nasdaq: SCUR) has an impressive client roster, but it's also competing with well-financed and experienced behemoths like Cisco Systems and EMC (NYSE: EMC).

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 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. For the past four and a half years, for example, Hidden Gems has beaten the market by more than 19 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 Motley Fool Hidden Gems, click here to try the service free for 30 days. There is no obligation to subscribe.

This article was originally published Oct. 8, 2007. It has been updated.

The Motley Fool holds stock in Berkshire Hathaway. Wal-Mart is an Inside Value selection. Berkshire Hathaway is a Stock Advisor and Inside Value recommendation. Total SA is an Income Investor pick. Secure Computing is a Rule Breakers pick. Dawson Geophysical is a Hidden Gems recommendation.

Rich Greifner's fantasy basketball team has great growth prospects, dedicated management, and an undesirable win-loss record. Rich owns Steve Nash, but he does not own any of the securities mentioned in this article. The Fool has a disclosure policy.