Do you know why Warren Buffett recently added to his position position in International Business Machines Corp (NYSE:IBM:NYSE) and The Kraft Heinz Co (KHC:NYSE) and has long held a position in behemoth Wal-Mart Stores Inc. (NYSE:WMT:NYSE)? In the latter case, it’s not because the world’s largest retailer is an untold secret, or growing earnings at 35% annually (it’s not), or because Buffett got a sweetheart deal (he didn’t). It’s simple: Buffett bought more shares in International Business Machines Corp (IBM:NYSE) and The Kraft Heinz Co (KHC:NYSE) because they are really, really big.
Yes, Wall-Mart is a solid company. But the law of large numbers tells us it is far more difficult to double profits from $15 billion than from a base of $1, $5, or even $17 million. Perhaps that is one reason he has been trimming his position of late.
For Buffett, bigger is better
Toward the beginning of Buffett’s investing career, it wasn’t uncommon for the Oracle (NYSE:ORCL) of Omaha to post 30% or 40% annual returns in Berkshire Hathaway’s (BRK-B NYSE:) 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.”
In the aftermath of the 2009 and in recent years, Buffett’s biggest investments were in blue-chip behemoths like Johnson & Johnson (NYSE: NYSE:JNJ ), Wal-Mart (WMT:NYSE) , and Wells Fargo (NYSE:WFC:NYSE) .
Those were all solid investment in great companies, to be sure, but it is unlikely they will propel Buffett’s portfolio to those 40% annual returns he generated in the past. And they certainly won’t help Buffett realize the 50% annual returns he famously stated he could achieve if he had less money to invest – and could invest in great small-cap stocks.
“Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.” – Warren Buffet
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 aweight!
So what would Buffett buy if he weren’t relegated to the realm of blue chips? We think he’d be scooping up shares of great 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 | 11.7% | 9.6% |
| 1973 to 2008 | 12.8% | 9.2% |
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 US$482 billion, Wal-Mart probably won’t be tripling that number anytime soon. The relatively tiny independent auto repair shop operator, Boyd Group Income Fund (BYD-UN:TSX)/(BFGIF:US OTC) US$57.59 on the other hand, one of the longest standing stocks on KeyStone’s Focus BUY List, has more than quadrupled its revenue over the past 8 years, increased earnings by more than 6 times, and its stock price skyrocketed as a result.
For comparison purposes, below we see that Wal-Mart was a decent buy in 2008 as the financial crisis hit and its shares traded in the $55 range. Over the past 8.5 years the stock has returned around 52% including dividends.
| Earnings Growth Rate | Total Stock Return (div. incl.) | |
| Boyd Group Income Fund | 38% | 3,200% |
| Wal-Mart Stores Inc. | 9% | 75% |
But the Small-Cap’s gains are astonishing over the same period. The Boyd Group and its simple car repair business which was recommended to KeyStone’s Premium Small-Cap Research clients in November of 2008 at $2.30, has seen it shares rocket to recently close at CDN$73.30. In fact, over that period the company has created such strong cash flow it has distributed over CDN$3.00 per share in distributions (dividends) to shareholders on top of the tremendous share price gains. Again it has paid us CDN$3.00 in cash and we bought the shares for CDN$2.30!
On top of their room to grow, small caps don’t attract much attention from Wall & Bay Street analysts. In fact, in 2008, KeyStone was the only research firm covering the Boyd Group. This means savvy investors are more likely to find mispriced stocks when fishing in small-cap waters. It appears that Bay Street is finally beginning to catch on to the Boyd Group story, but there are still dozens of compelling small-cap companies monitored by just one or two analysts or zero — 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.”
Even after the Boyd Group had seen its’ share price rocket over 30 fold over the past eight years, its market cap is is barely US$1 billion. Only about $2 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 billion purchase would barely register in Berkshire’ US$130 billion investment portfolio.
In other words, researching a small-cap company like the Boyd Group, 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 Boyd Group. 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 Boyd Group -like returns.
That’s why in addition to great growth prospects and limited (or no!) analyst coverage, our team of experts at KeyStone’s Small-Cap Research seeks out small caps that have:
- A strong balance sheet
- Positive cash flow
- Attractive Valuations
- Potential for a dividend (or dividend increase)
- A management team with a significant share ownership.
- A business we can understand.
- Operations in relatively safe jurisdictions.
- A positive industry outlook or niche outlook.
- Potential for hidden assets
- Market-beating potential over the next three to five years.
Unknown, Profitable Small-Cap BUY Under $4.00, Great Balance Sheet – Great Software Margins & Growth
In fact we just published research today on on a growing, cash rich NYSE-listed software company with over a quarter of its value in cash and no debt.
A recent quarterly earnings miss pushed the shared to correct 20% – we view this as a long-term opportunity for this profitable, cash producing software business with 90%+ customer retention rates that trades at half the value of its peers.
Our client are buying shares today and the stock is up 10%, but still offers good long-term value and growth rates in the range of 20-25% over the next 3-5 years.
Plus, this little software firm pays a dividend!
And it trades for under $4.00.
Warren Buffett might just wish he could buy this stock!
He can’t – but you could.