Forgo These Stocks That Legendary Investors Love

There's something to be said for riding the coattails of investing legends such as George Soros, Seth Klarman, and our favorite, Warren Buffett. After all, from 1976 to 2006, investors could have earned an average return of nearly 25% per year just by mimicking Buffett's investments.

But the real surprise is that investors could have achieved these returns even after Buffett's moves were disclosed in regulatory filings. That's the conclusion drawn by Professors Gerald Martin and John Puthenpurackal in their article "Imitation is the Sincerest Form of Flattery."

But there are at least several reasons you shouldn't blindly follow investing masters such as Buffett and his company Berkshire Hathaway (NYSE: BRK-B).

Following blindly
First, and despite the results above, we can't follow them all that closely -- and that matters. Regulatory disclosures can occur months after they've purchased shares, meaning the stock could have appreciated substantially in the meantime. These investors may be moving out of the stock just when you discover their purchases and are moving in.

Second, we don't know why they purchased the stock. Was it truly a rock-solid company or just a piece of trash that was severely mispriced and poised to pop when conditions improved?

Finally, you often can't discover why superinvestors sold a position. Perhaps the stock was at full value or, worse, maybe the fundamentals of the industry or company deteriorated, leaving the business in a distressing position. And just as with purchases, regulatory filings mean you don't know when sales happened.

It's also true that even superinvestors are wrong sometimes. Buffett admitted to squandering billions of Berkshire's investible cash on a position in ConocoPhillips (NYSE: COP), which he purchased near the top of the oil boom in 2008. In 2009, Buffett sold off his position to create a tax advantage, even though he liked the long-term prospects of the company. And given the volatility of oil prices in the last year and Conoco's vertical integration, which acts a natural hedge for most oil price environments, it's unclear when Buffett will think the company is ideally positioned for buying back in.

If you don't know the fundamental reasons Buffett bought a company, it's hard to know exactly why he sold and whether you should hold on to the stock or not.

You can do better elsewhere
Despite Buffett's spectacular returns throughout his career, his performance in the last decade has pulled down his average. The consistently great years of the '70s and '80s have been replaced by the merely good returns of the last 10 years.

But Buffett hasn't suddenly become less prescient -- far from it! His returns are hampered by the enormity of Berkshire Hathaway, where it takes a gargantuan purchase to meaningfully increase the size of his $172 billion mammoth.

And because huge companies simply don't have the room to grow that smaller companies do, it means that Buffett, like other legendary investors, has to endure lower returns as his status and performance grow.

That's the tragedy of any legendary investor, who can never again achieve the blistering growth of small-cap stocks.

Look at some recent purchases made by other legends and notice the common theme.

As you can see, these superinvestors love big companies -- Wal-Mart, Verizon, McDonald's -- they're enormous, one and all. But they love these big businesses only because they have to.

"Size is always a problem," Buffett told The Wall Street Journal. "With tiny sums [to invest], it's extraordinary what you can find. Most of the time, big sums are one hell of an anchor." In fact, Buffett has promised that he could achieve 50% returns every year as long as he had less than $1 million.

Where would he find such amazing performance? In unnoticed small-cap companies that can grow to the sky.

Get in on the ground floor
Of course, to invest in great small caps, you need to find them first -- and that means looking for high returns on capital and equity.

High returns on capital show that a company can expand relatively quickly with less reinvestment, allowing it to spin excess cash to shareholders. Similarly, high returns on equity show how well a company uses shareholders' -- your -- money. High-quality small-caps show high returns in both categories even before they go on to thump the market.

Source: Capital IQ.

Beware the super gaudy numbers, though, as they're likely not sustainable. For example, Arbitron is quite profitable, but it hasn't retained much of its earnings recently, deciding instead to pay down debt, and so its return on equity looks more tempting than if it had kept those earnings. Immunomedics' high returns on equity reflect the impact of negative retained earnings over the last few years, as the biotech ramped up revenue to profitable levels.

Before you purchase small caps, you need to look carefully at what's driving their numbers, rather than just assuming that higher numbers mean a better investment.

Friends in small places
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Jim Royal, Ph.D. owns shares in Berkshire Hathaway. Fossil is a Hidden Gems pick. Berkshire Hathaway and Wal-Mart are Inside Value picks. Berkshire Hathaway is a Stock Advisor recommendation. Blue Nile is a Rule Breakers recommendation. Bank Of Nova Scotia is an Income Investor recommendation. The Fool owns shares of Berkshire Hathaway. The Fool has a disclosure policy.