Buffett Wishes He Could Buy These Stocks

Do you know why Warren Buffett bought Burlington Northern Santa Fe (NYSE: BNI  ) ? It's not because the railroad operator has great growth prospects (it doesn't), or because Buffett got a sweetheart deal (he didn't). It's simple: Buffett bought Burlington Northern because the company is really, really big.

For Buffett, bigger is better
Toward the beginning of Buffett's investing career, it wasn't uncommon for the Oracle of Omaha to post 30% or 40% annual returns in Berkshire Hathaway's (NYSE: BRK-B  ) equity portfolio. But as the size of the capital base at Buffett's disposal grew larger, those stock returns began to shrink. "We do need to deploy cash, but we can't put many billions to work every year in spectacular businesses," Buffett said. "To move the needle at Berkshire, they have to be big transactions."

That's why Buffett was eager to drop $44 billion on Burlington Northern, even though he admitted that the company wasn't particularly cheap. It also explains why during last year's stock market meltdown, when many companies were trading at multiyear lows, Buffett's biggest investments were in blue-chip behemoths like Johnson & Johnson (NYSE: JNJ  ) , Wal-Mart (NYSE: WMT  ) , and Wells Fargo (NYSE: WFC  ) .

Those are all great companies, to be sure, but I doubt they'll help propel Buffett's portfolio to those 30% and 40% annual returns he used to generate. And they certainly won't help Buffett realize the 50% annual returns he famously boasted he could achieve if he had less money to invest.

Unfortunately, Buffett understands his predicament all too well. "Size is always a problem," Buffett told The Wall Street Journal's Jason Zweig. "With tiny sums [to invest], it's extraordinary what you can find. Most of the time, big sums are one hell of an anchor."

Anchors aweigh!
So what would Buffett buy if he weren't relegated to the realm of blue chips? I think he'd be scooping up shares of small-cap stocks. After all, they have historically outperformed large-cap stocks -- a gap that has widened over the past 35 years:

Annualized Return

Small Caps

Large Caps

1926 to 2008

11.7%

9.6%

1973 to 2008

12.8%

9.2%

Data from Ibbotson Associates.

Undoubtedly, Buffett could get these higher returns -- and better. Unfortunately, it's impossible for him to buy small-cap stocks. But before we get to why Buffett can't buy small caps, let's look at why small caps outperform in the first place.

Massive potential returns
By definition, smaller companies have much more room to grow. With annual revenue of about $405 billion, Wal-Mart probably won't be tripling that number anytime soon. Tiny education software provider Blackboard (Nasdaq: BBBB  ) , on the other hand, has tripled its revenue over the past five years, and its stock price has essentially followed suit.

On top of their room to grow, small caps don't attract much attention from Wall Street analysts. This means savvy investors are more likely to find mispriced stocks when fishing in small-cap waters. It appears that Wall Street has finally caught on to the Blackboard story, but there are still dozens of compelling small-cap companies monitored by just one or two analysts -- and many more that receive no analyst coverage at all.

Size matters
So why doesn't Buffett buy underfollowed small-cap stocks that could very well triple? It's simple: He can't.

Let's revisit Buffett's quote from earlier in the article: "We can't put many billions to work every year in spectacular businesses," Buffett said. "To move the needle at Berkshire, they have to be big transactions." (Emphasis mine.)

Even after Blackboard tripled in value over the past five years, its market cap is just $1.3 billion. Only about $15 million worth of stock trades hands each day. Buffett couldn't buy a stake in the company without driving the share price up significantly. And even if he were to buy the company outright, that $1.3 billion purchase would barely register in Berkshire's $170 billion investment portfolio.

In other words, researching a small-cap company like Blackboard, no matter how promising its prospects, simply isn't worth Buffett's time.

But it's definitely worth our time
Individuals who invest dollar amounts in the thousands, however, should be scouring the markets every day for the next Blackboard. It's the only way to even approach those 30% or 40% annual returns.

But be forewarned: Just because a company is small and underfollowed does not guarantee Blackboard-like returns. Consider the case of body armor manufacturer Ceradyne (Nasdaq: CRDN  ) , a former high-flying small cap that crashed to earth when its top customer -- the U.S. military -- slowed its spending.

That's why in addition to great growth prospects and limited (or no!) analyst coverage, our team of experts at Motley Fool Hidden Gems seeks out small caps that have:

  • A strong balance sheet;
  • A forthright management team;
  • A diversified customer base;
  • High and rising rates of return on equity; and, of course,
  • Market-beating potential over the next three to five years.

To see the latest Hidden Gems purchase -- a dirt cheap small cap covered by just four Wall Street analysts -- as well as the rest of the team's real-money buys, just click here to try the service free for 30 days. There is no obligation to subscribe.

Rich Greifner does not own shares of any of the companies mentioned in this article. Blackboard is a Hidden Gems recommendation. Berkshire Hathaway and Wal-Mart Stores are Inside Value recommendations. Berkshire Hathaway is a Stock Advisor selection, and the Fool owns shares of it. Johnson & Johnson is an Income Investor recommendation. The Fool has a disclosure policy.


Read/Post Comments (17) | Recommend This Article (133)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 04, 2010, at 2:50 PM, madmilker wrote:

    after tat drop from triple AAA....bet he is wishing tat CHOO! CHOO! ran on air and had a debt load of goose eggs.

  • Report this Comment On February 04, 2010, at 7:57 PM, Boomerchef wrote:

    I have a hard time putting faith in a company with the most tired pizza restaurants I have ever been in. KFC is doing well. Perhaps their other restaurants are, too, but I've never seen anything more deserving of embalming than a Pizza Hut - anywhere.

  • Report this Comment On February 05, 2010, at 4:36 AM, nickey2009 wrote:

    soon he might get it very cheap stocks are really going down and people are expecting more to come as they think of china bubble

    http://www.anxw.org

  • Report this Comment On February 05, 2010, at 9:01 AM, susan400 wrote:

    you miss the whole point

    3% isn't enough to offset small cap risks.

    many small caps went belly up,

    you didn't include those in your study.!!!

  • Report this Comment On February 05, 2010, at 10:50 AM, gimponthego wrote:

    Always have at least 500 shares of TAYD in the water. When the "Big One" bites, you'll want to catch it. Trading under $5 now, it's jumped to $9 from that price in an hour following a major seismic event. Were So. Cal. or San Francisco to ever have a major earthquake, the money made (if you buy on dips) would be Big as well.

    I've been told, "Gimpster. you're trading on other's misery." That earthquake is going to happen anyway, and if I can make money in the effort to open people's eye's to the fact Taylor Devices has already moved into wood frame residential housing, a move that will save lives, so much the better.

    I've held this stock for a decade and made money. IMO, the investor wanting to cover an important base might consider doing DD here, look at the price, the last Qtrly Report and decide for yourself. Best Of Luck!

  • Report this Comment On February 12, 2010, at 7:08 PM, bikingdoc wrote:

    There are lots of exciting small stocks out there, although Susan is right--the shameless MF promoters blithely ignore the elephant in the room with them--the risk!

    You might want to check out some companies with valuable commodity resources, pretty sure appreciate in coming inflationary environment--e.g. AMLM which is sitting on lots of lithium which many think is going to be in increasingly short supply.

    Hard to think this one isn't going up from here.

  • Report this Comment On February 13, 2010, at 1:23 AM, Latinus wrote:

    I got here by clicking on an item in Hotmail.

    Along this trip I was led to expect the names of four stocks.

    I still have not seen them. As for the general story about Buffet, I have known all that for over 20 years.

  • Report this Comment On February 13, 2010, at 1:24 AM, Latinus wrote:

    And now there is no easy way back to Hotmail.

  • Report this Comment On February 13, 2010, at 1:28 AM, Latinus wrote:

    My next complaint did not get posted. Did I forget to click on "Post Your Comment"?

  • Report this Comment On February 13, 2010, at 1:30 AM, Latinus wrote:

    Now I do see that complaint.

    -

    Anyway, the easy way back to Hotmail is to close this window.

  • Report this Comment On February 13, 2010, at 2:31 AM, Arjunmarkanda wrote:

    you should have included the followings stock in your report.

    EONC

    Market cap - $10m

    Outstanding shares 2.74M

    Company makes profit.Great acquisition candidate.

    Currently very cheap under $4

    so if you people really wanna make money, this is the stock to buy and hold until it reaches $7 as it did in January 2010.

  • Report this Comment On February 28, 2011, at 1:49 PM, applegate888 wrote:

    I like wsp 1.33 -7.50 in in 09.

  • Report this Comment On April 12, 2011, at 9:30 PM, legend7kt321 wrote:

    I am dumb, but at last I found this page, getting there slowly. Hi Y'all, and G'day

  • Report this Comment On August 25, 2011, at 5:13 AM, joepennies wrote:

    The main advantages for these small cap stocks - high profit potential and under-followed are 2 of the main advantages I see for trading penny stocks too - EXCEPT... it's even better I think...

    You can multiply the profit potential by at least 10 and expect to be able to "take" the profit in at least 1/10 of the time. Penny stocks are essentially "super" small caps!

    Joe Wolfe

    http://how-to-make-money-with-penny-stocks.blogspot.com/

  • Report this Comment On August 19, 2012, at 12:32 PM, callmegodfather1 wrote:

    You must suffer for art.

  • Report this Comment On January 18, 2013, at 6:47 PM, chris293 wrote:

    You can win a lot or lose a lot. Be careful. Why do you want to suffer foolishly?

  • Report this Comment On January 24, 2014, at 4:28 PM, JoeyB wrote:

    Hey watch out for WEN, Wendy's. I bought at 4.50 now running at 9.05. One of the cheaper hamburger joints. MCD having problems, BK is a ? Since they broke from Arbey's has gone up. Given top rating on burger, clean, and still cheaper stock than other companies. I could see this going up to 15-16 by end of year.

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