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Buffett Small Cap Investing
Those 50% Returns

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By mklein9
December 26, 2006

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Today's market is reasonably efficient, but efficiency, defined maybe as price/intrinsic value, seems to fall the smaller the companies we look at. However, even among the smallest companies, most appear to be reasonably well priced. But of course not all, and as investors in individual stocks we care only about whether we find the exceptions and care not about generalities.

But, small companies also have limited opportunities to make their existence known, since nobody seems to be paying attention in the first place. To achieve 50% returns Buffett has said you need to look in obscure places, probably small companies. I have seen a few companies that look grossly undervalued but just stay that way. That doesn't help achieve 50% returns.

I think that the best hints from Buffett's early days are the "workouts" which are mispricings that exist until some event occurs that is not dependent on the market in general. This means catalyst. A great example that I believe is unfolding right now is USG, in which Buffett is taking a large stake right now, but I feel unable to really appreciate the value he sees in it. Examining this case in some detail might help us understand the required mindset.

So I believe that the investment strategy to achieve 50% returns needs to include:

1) Of course, highly undervalued companies, usually meaning small and ignored, and frequently with confusing or complex seeming conditions causing a low price that, under closer inspection, are not so bad after all.

2) Near-term catalysts that cause price correction to occur.

3) Relatively short time frames for holding (1 year, maybe less.)

4) Fairly extreme concentration where payoff/risk is very high (similar to betting an edge/odds fraction as done in the Kelly Criterion.)

Buffett's implication is that he can achieve 50% returns consistently, not just due a fluke.

If we examine what this means, it probably means in most years achieving higher than 50% returns, maybe 60%. If we figure on 10 investments/year as a hypothetical round number (it could be 5 or 20 or 50), and 3 of them don't do what we think over the 1-year period and return 0%, then the remaining 7 must achieve an average of 71%.

What kinds of investments achieve an average of 70% in a year? We could break this down further into time frames. If we hold our investments for an average of 6 months, they "only" need to return 31%. If we hold them for 5 years, they would need to return 1360%. That latter number sounds essentially impossible except in the smallest of extreme cases. My belief is that to achieve the 50% range of annual returns, the holding periods need to be short, and the price increases need to be quick. Therefore there must be a catalyst clearly visible to correct the price. If it's not there and doesn't seem to be appearing soon, sell and move on.

I just tried testing this with a simple modification to the HG-Type screen I run weekly (results are posted to a subscription Hidden Gems board, but results are also given as web pages on my own site). I took the stocks that were picked by the screen since I started running it on 6/1/04 and, without regard for any other factors, sold them at 6 months. Guess what -- the IRR of that strategy is 46%. Take a look: http://invest.kleinnet.com/hg/hg-current-sell6m.html . Standard caveats apply such as no frictional costs are included, and some of these stocks are very thinly traded so costs could be substantial. However, this particular study has no survivorship bias (I maintain the portfolio through all corporate events), so I do not think it is too terribly far off reality. IRR only expresses the returns on actual cash flows, and assumes equal allocation to each stock, so it only partly reflects the return can be expected from a portfolio of limited size and non-zero cash balance.

In terms of identifying catalysts, I would guess there are two kinds: 1) (preferably) business related catalysts, and 2) the market is showing us that investors are paying attention and the price is responding, i.e. momentum. If the set of stocks in the example above had been further selected by catalyst (a business catalyst or momentum), it would be interesting to see the returns, although that is going to be much harder to do with hindsight without falling for the typical back testing biases.

That is my theory at this point for how to achieve very high returns. It will be highly time-intensive work to identify a stream of stock ideas that can return 31% in 6 months or 43% in 8 months or 71% in 12. And it will require the fortitude to both 1) take the gains in a fairly short time and plow the money back into the next ideas, and 2) give up on those where the catalyst isn't showing up and put the money to work on another idea.

-Mike


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