Buffett: Too Big to Succeed

Want to make a fortune in the stock market? I have one simple piece of advice for you: Don't invest like Warren Buffett.

Please put down your pitchforks
To be perfectly clear, I firmly believe that Buffett remains the greatest investor in the world. His candid, folksy, and self-effacing annual letters to Berkshire Hathaway (NYSE: BRK-B) shareholders have provided a fundamental foundation for countless investors over the years, myself included. But even the most ardent Buffett admirers must admit: Buffett's best days are behind him, and they're not coming back.

How the mighty have fallen
In the early years of his investing career, Buffett routinely beat the S&P 500's return by double-digit percentages. But as time passes, that margin of outperformance has narrowed. Just check out the chart below:

Source: Berkshire Hathaway 2009 annual report.
*Berkshire's performance is measured by percentage change in per-share book value, after taxes. S&P 500 performance is pre-tax and includes dividends.

While beating the S&P index by 7.6 percentage points over the last decade is still a remarkable achievement, it falls far short of Buffett's historical performance. And it pales in comparison to the 50% annual returns Buffett famously boasted he could achieve.

Why have the Oracle of Omaha's investing results receded over time? It's not because he has lost his magic touch – in fact, the modern-day Buffett is more experienced, better connected, and sharper than ever. Instead, the reason why Buffett has struggled is simple: Berkshire Hathaway is too damn big.

Don't just take my word for it
As the years have passed, and the capital base at Buffett's disposal has increased, his ability to produce market-trouncing returns has greatly diminished. Here's what Buffett has had to say about this dilemma over the years:

1991: "As Berkshire grows, the universe of opportunities that can significantly influence the company's performance constantly shrinks."

1995: "The giant disadvantage we face is size: In the early years, we needed only good ideas, but now we need good big ideas."

1998: "One thing is certain: our future rates of gain will fall far short of those achieved in the past. Berkshire's capital base is now simply too large to allow us to earn truly outsized returns."

2001: "We need 'elephants' to make significant gains now -- and they are hard to find."

I could go on, but I think you get the point. To illustrate how burdensome Berkshire's weight has become, consider that when Buffett first started expressing his concerns in 1991, the company's equity capital base stood at $7.4 billion. Today, it's a whopping $131.1 billion.

Elephants weigh you down
This factor best explains why Buffett's relative returns have diminished in recent decades. Berkshire's massive capital base has relegated his investment opportunities to the realm of behemoth blue-chip firms like Coca-Cola (NYSE: KO), Johnson & Johnson (NYSE: JNJ), Wells Fargo (NYSE: WFC), and Wal-Mart (NYSE: WMT).

While those are all outstanding companies, their dominance is well-known and widely acknowledged by both Wall Street and the financial media. Current investors can take comfort that the world's greatest stock picker likes them, but again, he's very limited as to where he can go picking. Stocks like that are rarely mispriced -- and highly unlikely to produce the type of market-thumping returns Buffett used to post on a routine basis.

Even worse, Berkshire's structural disadvantage has forced Buffett to alter his investing style. Consider this excerpt from Berkshire's latest shareholder letter:

In earlier days, Charlie [Munger] and I shunned capital-intensive businesses such as public utilities. Indeed, the best businesses by far for owners continue to be those that have high returns on capital and that require little incremental investment to grow. We are fortunate to own a number of such businesses, and we would love to buy more. Anticipating, however, that Berkshire will generate ever-increasing amounts of cash, we are today quite willing to enter businesses that regularly require large capital expenditures. We expect only that these businesses . . . should produce above-average, though certainly not spectacular, returns in the decades ahead.

In other words, Buffett can still identify great businesses ... but now he must bypass them for companies that consume massive amounts of capital and deliver lower returns. Essentially, he's now fighting with one hand tied behind his back.

Bad for Buffett, good for us
Buffett's approach makes perfect sense for institutions managing billions of dollars of capital. But it's a downright foolish (note the lower-case "f") approach for investors like you and me who invest in thousand-dollar increments.

Instead, we should be on the lookout for the kind of opportunities that Buffett used to hunt for -- tiny, underfollowed companies with high returns on capital and minimal capital expenditure requirements.

Companies like Blue Nile (Nasdaq: NILE), the online jeweler whose low overhead costs allow it to underprice its brick-and-mortar peers and still post significantly higher returns on invested capital.

Or Houston Wire and Cable (Nasdaq: HWCC), a tiny distributor of specialty wire and cable that boasts steady recurring revenue, a significant growth opportunity, and ridiculously low capital expenditure requirements.

These are the kind of companies with the potential to be the best-performing stocks of the next 10 years, and not just produce "above-average, though certainly not spectacular, returns in the decades ahead." In other words, they're the kind of companies Buffett wishes he could buy.

Fortunately, they're also the kinds of companies that our small-cap experts scour the market for every day at Motley Fool Hidden Gems. To see which stocks the Hidden Gems team is buying, just click here to take a 30-day free trial.

Rich Greifner has 99 problems, but a bloated capital base ain't one. Rich does not own shares of any company mentioned in this article. Berkshire Hathaway, Coca-Cola, and Wal-Mart Stores are Motley Fool Inside Value selections. Blue Nile is a Motley Fool Rule Breakers pick. Berkshire Hathaway is a Motley Fool Stock Advisor recommendation. Johnson & Johnson and Coca-Cola are Motley Fool Income Investor picks. Motley Fool Options has recommended buying calls on Johnson & Johnson. The Fool owns shares of Berkshire Hathaway. The Fool's disclosure policy is just the right size to do OK.