No one would dispute that Warren Buffett is a superb investor. His stellar performance across decades, and his oracular wisdom in finance and life, make Buffett a living legend. Given all that success, should you imitate Buffett's moves in the stock market, trying to ride his coattails to wealth? Maybe not.

It's becoming increasingly difficult for Buffett to live up to the past performance that has made him a legend. And he admits as much. For this reason and one other, which I'll address in a minute, you can do quite well in the stock market by never buying a single one of the stocks that Buffett-run Berkshire Hathaway (NYSE: BRK-B) does. It's yet another reason you should forgo the stocks that legendary investors love.

A man for all seasons
Research has shown that, from 1976 to 2006, investors could have achieved an average annual return of almost 25% just by copying Buffett's investments. Amazingly, investors could have earned these returns even after Berkshire's moves were revealed in regulatory filings. That's the conclusion drawn by Professors Gerald Martin and John Puthenpurackal in their article "Imitation is the Sincerest Form of Flattery."

And while Buffett's performance has been great, it's been slowing markedly in recent years. Take a look at the change in Berkshire's book value by decade:


Average Annual Increase in Book Value of Berkshire Hathaway

Increase in S&P with Dividends Included

Relative Performance





















Source: Berkshire Hathaway's 2008 annual letter.

As you can see, Buffett's performance has distinctly declined as Berkshire has grown into a massive conglomerate.

Pay particular attention to the relative performance column, which should iron out some of the peculiarities of each era, such as the 1990s, when a monkey could day-trade kitchen sinks for profit. While Buffett scored annual returns of 40% or more three times in the 1980s, he managed it only twice in the 1990s, and not at all from 2000 to 2007. (Of course, let's not pity Buffett too much: From 1965 to 2009, he managed to deliver a 600,000% cumulative return.)

Now, don't get me wrong; consistently beating the market by even "just" 6 or 7 percentage points per year is a glorious feat, but such outperformance can't last when Buffett himself repeatedly laments his fate.

A stock small enough for the job
"Size is always a problem," Buffett told The Wall Street Journal. "With tiny sums [to invest], it's extraordinary what you can find. Most of the time, big sums are one hell of an anchor." Incredibly, Buffett vowed that he could consistently achieve 50% returns annually as long as he had less than $1 million. With this much smaller portfolio, Buffett would purchase small-cap stocks, which over long stretches have been outperformers.

Instead, the Oracle of Omaha is stuck in large caps, and he's focused on the most solid names. As of year's end, Berkshire owned:

  • 444 million shares of Wells Fargo (NYSE: WFC), for its low cost of funds. Wells has long been known for its ability to gather deposits cheaply.
  • 87.5 million shares in Procter & Gamble (NYSE: PG), for its highly lucrative and resilient consumer brands. In fiscal 2009, P&G turned every dollar of sales into $0.17 of pure profit.
  • A position of 38 million shares in ConocoPhillips (NYSE: COP) and a smaller stake in ExxonMobil (NYSE: XOM), for their exposure to energy. Because they're exposed to the length the oil production chain, these vertically integrated companies offer natural hedges in different oil price environments, making them more stable than less integrated competitors. Their size and financial liquidity offer additional stability.

These positions – and the many others in Berkshire's portfolio – are the companies that you and everybody's Aunt Mary are familiar with. But despite the competitive advantages of these large caps, they're not where you're going to find the stocks that will rise 10 or 20 times in value over the next decade.

The opportunity for multibaggers does not come from the household names of today, but from the barely known and underfollowed small-cap companies that Wall Street hasn't discovered yet. Such small caps can offer rock-solid fundamentals and attractive growth prospects, which can quickly turn them into the super-lucrative household names of tomorrow.

The way forward
Finding such overlooked but rock-solid companies is the task at the Motley Fool Hidden Gems newsletter, run by co-advisors Seth Jayson and Andy Cross. These expert analysts are following Under Armour (NYSE: UA), an athleticwear company that is successfully challenging Nike, and Chipotle (NYSE: CMG), a moneymaking restaurant chain that's changing the face of fast food. Both of these diamonds in the rough are highly profitable, growing quickly, and not so well-known that everybody already owns them. But the newsletter has purchased shares of both for its real-money portfolio.

If you'd like our experts to help you find superior small-cap ideas and tell you when to buy (before we do), you can check out all of our Hidden Gems stock research, as well as our eight "Buy First" small caps for new money now, free for the next 30 days.

Click here for more information.

Already a Hidden Gems member? Log in here.

Jim Royal, Ph.D. owns shares in Berkshire Hathaway, Procter & Gamble and Bank of America. Berkshire is a selection of Inside Value and Stock Advisor. Chipotle and Under Armour both are Rule Breakers and Hidden Gems picks. Procter & Gamble is an Income Investor selection. The Fool owns shares of Berkshire, Chipotle, Procter & Gamble, and Under Armour. The Fool has a disclosure policy.