Warren Buffett is a living legend -- a self-made billionaire who has used common sense and a disciplined approach to valuation to trounce the market for the past four decades. Since 1965, Buffett has amassed 21.4% compounded annual returns and turned a $10,000 initial investment into more than $36 million today. That's crazy.

I'll be shocked if he can keep it up.

No, I haven't been drinking
Even at the ripe old age of 78, Buffett remains one of the world's sharpest investing minds. But with $31 billion in cash at his disposal, he has primarily relegated his equity investments to the realm of well-known large-cap stocks, such as American Express (NYSE:AXP), GlaxoSmithKline (NYSE:GSK), and Comcast (NASDAQ:CMCSA).

While investing in these corporate titans is a fine way to preserve your capital (and buying on the cheap should help Buffett continue to beat the market), buying into such behemoths won't earn anyone 21.4% annual returns for an extended period of time. And it certainly won't approach the mythical 50% annual returns that Buffett once famously boasted he could achieve if he had less money to invest.

But don't take my word for it. Buffett said the exact same thing at Berkshire Hathaway'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.

Expand your universe
So where would Buffett look, if he could? How about in small-cap stocks? After all, they have historically outperformed large-cap stocks -- a gap that has widened over the past 30 years:

Annualized Return

Small Caps

Large Caps

1926 to 2006



1976 to 2006



Data from Ibbotson Associates.

Undoubtedly, Buffett could get these returns. Unfortunately, small-cap investing would scarcely budge his portfolio. But before we get to why Buffett won't buy small caps, let's look at why small caps outperform in the first place.

Massive potential returns
First and foremost, smaller companies have much more room to grow. With annual revenue of nearly $42 billion, PepsiCo (NYSE:PEP) probably won't be doubling that number anytime soon. Tiny Green Mountain Coffee Roasters (NASDAQ:GMCR), on the other hand, has seen its revenue double over the past two years, and its stock price has essentially followed suit.

On top of that, a mere six Wall Street analysts follow Green Mountain. In other words, even though the company's potential is plain as day, its small size means that few of the big Wall Street firms are even looking at it.

A little ain't enough
Why does Wall Street ignore stocks that could very well double?

For some of the same reasons Buffett does. When you have a lot of money, even the best-performing small companies won't juice your returns. Just consider, for example, if Berkshire had bought Green Mountain (now valued around $760 million) whole hog when it was a $380 million company. That $380 million double to date would have moved Berkshire's $69.5 billion equity portfolio just 0.5%.

Investors of all sizes will agree: There's no point in researching an idea if it will provide just 0.5% potential gains.

Every rose has its thorn
Individuals who invest dollar amounts in the thousands, however, should be scouring the markets every day for the next Green Mountain Coffee Roasters. It's the only way to even approach those aforementioned 50% annual returns.

But be forewarned: Small-cap stocks are volatile. Tiny storage networking solutions supplier QLogic (NASDAQ:QLGC) boasts strong market share and an impressive customer base, but it's also competing with a number of well-financed and experienced behemoths, such as Cisco Systems and Broadcom (NASDAQ:BRCM).

The best of both worlds
To be better than Buffett, you need to invest in the cream of the small-cap crop -- stocks that offer great appreciation potential and, because of their compelling valuations, provide downside protection.

That's what we do at Motley Fool Hidden Gems, where we find stocks that, like QLogic, have:

  • Great growth prospects.
  • Dedicated management.
  • A strong balance sheet.
  • An undervalued stock price.

Yes, there will be volatility. Yes, some of these stocks may lose money. But the potential rewards are real, and they're spectacular. Since 2003, for example, Hidden Gems has beaten the market by more than 13 percentage points on average.

You can do the same -- and beat the Oracle of Omaha in the process -- as long as you make the most of your advantages as an individual investor and know what you're doing. If you'd like help from Motley Fool Hidden Gems, click here to try the service free for 30 days. There is no obligation to subscribe.

This article was originally published Oct. 8, 2007. It has been updated.

The Motley Fool holds stock in Berkshire Hathaway and American Express. Berkshire Hathaway is a Stock Advisor and Inside Value recommendation. American Express is an Inside Value selection. GlaxoSmithKline is an Income Investor pick.

Rich Greifner 's fantasy football team has great growth prospects, dedicated management, and an undesirable win-loss record. Rich owns Marion Barber, but no shares of any company mentioned in this article. The Fool has a disclosure policy.