The Man Who's Shorting Buffett

There are certain things in life you just don't do. You don't tug on Superman's cape. You don't spit into the wind. You don't pull the mask off that ol' Lone Ranger, and you definitely don't short Warren Buffett. 

Apparently, that's a lesson Doug Kass is determined to learn the hard way.

A short introduction
Kass is the founder of Seabreeze Partners, a fund dedicated to selling stocks short. According to Seabreeze's Web page, Kass seeks "a view which differs from the market's prevailing bias." I think it's safe to say that by shorting Berkshire Hathaway, Kass has successfully found the variant view he was seeking.

In a recent article and a brief debate on CNBC (video clip requires registration) with my Foolish friend Bill Barker, Kass presented his case against Berkshire. Although I found most of his arguments weak, I will admit that his position is not entirely without merit.

But there's one equation that Kass has overlooked -- and I think it will cost him, big time.

Buffett + cash + cheap stocks = $$$
The Oracle of Omaha is sitting on a $38 billion war chest, and he's likely licking his chops as the stocks of quality companies get punished alongside their less polished peers. As Bill Barker astutely noted in that CNBC segment, "You have to respect ... the equation of Buffett armed with a whole lot of money and better values out in the market."

In this type of environment, Berkshire may finally have the opportunity to deploy some of the cash it has been criticized for sitting on. Should the market pick up from here, we're staring at a serious potential catalyst.

So I wouldn't be caught dead shorting the stock -- but I'm also in no hurry to buy Berkshire shares. There are better bargains out there right now.

Better bargains than Berkshire
My colleagues and I have been saying for weeks now that many good stocks were outrageously cheap. I have no doubt that Buffett has noticed this as well. But while we're free to exploit Wall Street inefficiencies and pick the cheapest stock around, Buffett is extremely limited in what he can buy.

As I've pointed out before, it's simply not worth Buffett's time to research or buy small-cap stocks. Berkshire is so large that even owning the best-performing small-cap stocks won't noticeably budge its bottom line. Buffett himself admitted as much at Berkshire'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.

Small wonders
Fortunately for those of us who make investments in "three-zero" denominations, there are plenty of potential bargains out there. Here are a few of Berkshire's biggest holdings, and a small-cap alternative in a similar niche that I believe will provide greater stock price appreciation:

If you like:

Company	Industry	Market Cap	Expected 5-year Growth Rate
Ingersoll-Rand (NYSE: IR)	Diversified Machinery	$11.8 billion	13.2%
Iron Mountain (NYSE: IRM)	Business Services	$5.8 billion	22.7%
Home Depot (NYSE: HD)	Home Improvement	$46.1 billion	11.0%

Consider investing in:

Company	Industry	Market Cap	Expected 5-year Growth Rate
Actuant (NYSE: ATU)	Diversified Machinery	$2.0 billion	14.8%
Heartland Payment Systems (NYSE: HPY)	Business Services	$972 million	22.3%
Builders FirstSource (Nasdaq: BLDR)	Home Improvement	$266 million	11.6%

Data from Yahoo! Finance.

Smaller is better
Small-cap stocks may not be appropriate for Warren Buffett's portfolio, but if your net worth isn't measured in billions, it might make sense to increase your exposure to this segment. That's especially true in volatile markets like today's, where investors tend to punish small caps excessively, allowing us to buy our favorite companies on the cheap. 

At our Motley Fool Hidden Gems investing service, we've identified a number of small-cap stocks that we believe are poised to crush the returns of both the general market -- and maybe even Berkshire Hathaway. You can read detailed recommendations of all our small-cap picks and see our best bets for new money now by joining the service free for 30 days.

This article was originally published March 24, 2008. It has been updated.

Rich Greifner loves small-cap stocks and mid-major schools. He does not own shares in any company mentioned in this article. The Motley Fool owns shares of Berkshire Hathaway. Actuant and Heartland Payment Systems are Hidden Gems recommendations. Berkshire Hathaway, Home Depot, and Builders FirstSource are Inside Value picks. Berkshire is also a Stock Advisor selection. The Fool has a disclosure policy.