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 $33 billion in cash at his disposal (as of Sept. 30), he has primarily relegated his equity investments to the realm of well-known large-cap stocks, such as Burlington Northern (NYSE:BNI), Ingersoll-Rand (NYSE:IR), and Tyco International (NYSE:TYC).

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

12.7%

10.4%

1976 to 2006

17.5%

12.8%

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 about $185 billion, General Electric (NYSE:GE) probably won't be doubling that number anytime soon. Tiny Epiq Systems (NASDAQ:EPIQ), on the other hand, has seen its revenue double over the past three years, and its stock price has essentially followed suit.

On top of that, a mere three Wall Street analysts follow Epiq Systems. 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 Epiq Systems (now valued around $588 million) whole hog when it was a $294 million company. That $294 million double to date would have moved Berkshire's $76 billion equity portfolio just 0.4%.

Investors of all sizes will agree: There's no point in researching an idea if it will provide just 0.4% 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 Epiq Systems. It's the only way to even approach those aforementioned 50% annual returns.

But be forewarned: Small-cap stocks are volatile. Tiny MicroStrategy has an impressive collection of customers, but it's also competing with well-financed and experienced behemoths like Oracle (NASDAQ:ORCL) and SAP (NYSE:SAP).

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 Epiq Systems, 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 eight 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.

Rich Greifner 's fantasy football team has great growth prospects, dedicated management, and an undesirable win-loss record. Rich owns Marion Barber's balky toe, but no shares of any company mentioned in this article. The Motley Fool owns shares of Berkshire Hathaway. Berkshire Hathaway is a Motley Fool Stock Advisor and Inside Value recommendation. Tyco is also an Inside Value selection. The Fool has a disclosure policy.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.