Warren Buffett's Humorous Threat

Along with being the world's greatest living investor, Warren Buffett is an outstanding writer, a generous educator, and a reliable wit. His annual letters to shareholders, replete with investing insights both timely and timeless, nearly always include a number of well-delivered jokes.

In one letter, he wrote:

We show below our common stock investments. With two exceptions, those that had a market value of more than $700 million at the end of 2006 are itemized. We don't itemize the two securities referred to, which have a market value of $1.9 billion, because we continue to buy them. I could, of course, tell you their names. But then I would have to kill you.

Now, when I first read that, I laughed. The notion that Buffett might need to off one or more of his readers is just good comedy. Then I thought, "Was it Freud or an embittered ex-girlfriend of mine who said that there really is no such thing as an innocent joke?" (I know that one smoked a lot of cigars, and one needs to get over my remark about her bad haircut.)

But I digress
Whoever it was, there's a lesson in Buffett's joke (as there is in making light of a lovely mohawk), and it is not completely innocent. I could deconstruct all the parts of the joke -- the setup, paradox, denouement, and release -- but dissecting humor and frogs tends to leave both subjects dead.

Buffett's lesson is this: He ain't going to tell you what he's buying, because that information creates attention around the stocks, fundamentally altering the price at which he would continue buying shares. Much as he'd like to leave you alive -- for the sake of Berkshire Hathaway's shareholders, if the information slipped out -- he'd simply have a fiduciary duty to terminate you with extreme prejudice.

Buffett, master investor that he is, wants to buy stocks that are operating in the absence of any excess attention -- as should you. That isn't easy for Buffett. He's allocating capital at levels that require small purchases of very large stocks, and there is generally a fair amount of attention focused on the largest-capitalized companies. Small-cap stocks tend to benefit from having less attention focused on them, and therefore more of them (and a greater percentage of them) are likely to be mispriced.

That should be the cornerstone of any investor's market-beating portfolio: small-cap stocks in general, but in particular, small caps free of the investing public's attention.

Attention and asset prices
In that regard, a fascinating study has recently been released. It's titled "Attention and Asset Prices: The Case of Mad Money," and it examines the effects of sudden attention on stock prices, both large-cap and small-cap. The abstract for the report pretty much sums up the findings of the study:

We document market inefficiency in the days following the buy recommendations of Jim Cramer, host of the popular CNBC show Mad Money. The average overnight return following a first-time recommendation by Cramer is 2.86% for our entire sample and 6.76% for the smallest quartile, but these gains disappear (reverse) within several trading days. We also find that trading volume and short sales volume are all significantly higher than normal on the day following Cramer's recommendations.

The report doesn't seek to measure the long-term value of Mad Money's stock recommendations, but instead measures the effects of the immediate attention on the stock price. For stocks featured on the live program that aired April 23, 2008, the effects seem pretty consistent with the study's findings.

Stocks mentioned in the lightning round, although often receiving as much or more praise or condemnation as opening-round stocks (measured by screams and sirens), don't really move. "Lightning-round" stocks weren't measured in the study -- just stocks treated at length in segments such as the opening round.

Stocks routinely jump more than 5% and see a significant spike in volume, thanks to a fairly brief mention on a television show that has a new episode coming out almost daily. Imagine the kind of effect "Warren Buffett is buying!" would have on any stock. Even in large caps, the effect would probably be even more dramatic and more sustained than the so-called Mad Money effect.

Search the shadows
And so, like Buffett, you should focus on stocks and companies that are out of the limelight. Unlike Buffett, you have the opportunity to purchase small-cap companies, which have historically proven to have significantly better returns than large caps.

That's what we do at Motley Fool Hidden Gems. Focusing exclusively on little-known, low-attention stocks has led us to average gains of 38% since inception in 2003, vs. gains of 13% for the S&P 500. If you'd like a free, 30-day trial of our service, it's yours for the taking. At that price, I'd advise that it's probably worth it.

And allow me to offer another piece of advice: Don't ask Buffett what he's buying. Nothing good can come of that.

On May 2, advisors Bill Mann, Seth Jayson, and Philip Durell head to Omaha, Neb., to represent you at the Berkshire Hathaway annual meeting. To read their real-time dispatches on each day's events, enter your email address in the box below. It's free, and there's no obligation.