Do you know why Warren Buffett bought Burlington Northern Santa Fe (NYSE:BNI)? It's not because the railroad operator has great growth prospects (it doesn't), or because Buffett got a sweetheart deal (he didn't). It's simple: Buffett bought Burlington Northern because the company is really, really big.

For Buffett, bigger is better
Toward the beginning of Buffett's investing career, it wasn't uncommon for the Oracle of Omaha to post 30% or 40% annual returns in Berkshire Hathaway's (NYSE:BRK-B) equity portfolio. But as the size of the capital base at Buffett's disposal grew larger, those stock returns began to shrink. "We do need to deploy cash, but we can't put many billions to work every year in spectacular businesses," Buffett said. "To move the needle at Berkshire, they have to be big transactions."

That's why Buffett was eager to drop $44 billion on Burlington Northern, even though he admitted that the company wasn't particularly cheap. It also explains why during last year's stock market meltdown, when many companies were trading at multiyear lows, Buffett's biggest investments were in blue-chip behemoths like Johnson & Johnson (NYSE:JNJ), Wal-Mart (NYSE:WMT), and Wells Fargo (NYSE:WFC).

Those are all great companies, to be sure, but I doubt they'll help propel Buffett's portfolio to those 30% and 40% annual returns he used to generate. And they certainly won't help Buffett realize the 50% annual returns he famously boasted he could achieve if he had less money to invest.

Unfortunately, Buffett understands his predicament all too well. "Size is always a problem," Buffett told The Wall Street Journal's Jason Zweig. "With tiny sums [to invest], it's extraordinary what you can find. Most of the time, big sums are one hell of an anchor."

Anchors aweigh!
So what would Buffett buy if he weren't relegated to the realm of blue chips? I think he'd be scooping up shares of small-cap stocks. After all, they have historically outperformed large-cap stocks -- a gap that has widened over the past 35 years:

Annualized Return

Small Caps

Large Caps

1926 to 2008



1973 to 2008



Data from Ibbotson Associates.

Undoubtedly, Buffett could get these higher returns -- and better. Unfortunately, it's impossible for him to buy small-cap stocks. But before we get to why Buffett can't buy small caps, let's look at why small caps outperform in the first place.

Massive potential returns
By definition, smaller companies have much more room to grow. With annual revenue of about $405 billion, Wal-Mart probably won't be tripling that number anytime soon. Tiny education software provider Blackboard (NASDAQ:BBBB), on the other hand, has tripled its revenue over the past five years, and its stock price has essentially followed suit.

On top of their room to grow, small caps don't attract much attention from Wall Street analysts. This means savvy investors are more likely to find mispriced stocks when fishing in small-cap waters. It appears that Wall Street has finally caught on to the Blackboard story, but there are still dozens of compelling small-cap companies monitored by just one or two analysts -- and many more that receive no analyst coverage at all.

Size matters
So why doesn't Buffett buy underfollowed small-cap stocks that could very well triple? It's simple: He can't.

Let's revisit Buffett's quote from earlier in the article: "We can't put many billions to work every year in spectacular businesses," Buffett said. "To move the needle at Berkshire, they have to be big transactions." (Emphasis mine.)

Even after Blackboard tripled in value over the past five years, its market cap is just $1.3 billion. Only about $15 million worth of stock trades hands each day. Buffett couldn't buy a stake in the company without driving the share price up significantly. And even if he were to buy the company outright, that $1.3 billion purchase would barely register in Berkshire's $170 billion investment portfolio.

In other words, researching a small-cap company like Blackboard, no matter how promising its prospects, simply isn't worth Buffett's time.

But it's definitely worth our time
Individuals who invest dollar amounts in the thousands, however, should be scouring the markets every day for the next Blackboard. It's the only way to even approach those 30% or 40% annual returns.

But be forewarned: Just because a company is small and underfollowed does not guarantee Blackboard-like returns. Consider the case of body armor manufacturer Ceradyne (NASDAQ:CRDN), a former high-flying small cap that crashed to earth when its top customer -- the U.S. military -- slowed its spending.

That's why in addition to great growth prospects and limited (or no!) analyst coverage, our team of experts at Motley Fool Hidden Gems seeks out small caps that have:

  • A strong balance sheet;
  • A forthright management team;
  • A diversified customer base;
  • High and rising rates of return on equity; and, of course,
  • Market-beating potential over the next three to five years.

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Rich Greifner does not own shares of any of the companies mentioned in this article. Blackboard is a Hidden Gems recommendation. Berkshire Hathaway and Wal-Mart Stores are Inside Value recommendations. Berkshire Hathaway is a Stock Advisor selection, and the Fool owns shares of it. Johnson & Johnson is an Income Investor recommendation. The Fool has a disclosure policy.