Small investors can beat Warren Buffett at investing and earn 50% annual returns based on Buffett’s own investment principles. You see, Buffett himself admits that, while he aims to beat the S&P 500 by several percentage points per year on average, he can’t outperform the market by as much as he used to. It’s not because he’s old; it’s because the size of his portfolio is so huge.

According to Warren Buffett’s 2011 shareholder letter, Berkshire Hathaway’s (NYSE: BRK-A) (NYSE: BRK-B) investment portfolio of stocks, bonds and cash totals more than $164 billion! Buffett bemoans the fact that he can no longer buy the high-growth, small-cap stocks that produced such stellar investment returns for Berkshire in its early years.

The larger the pot of money to invest, the worse off investment returns will be. Back in 1999, Buffett was quoted as saying the following:

If I had $10,000 to invest, I would focus on smaller companies because there would be a greater chance that something was overlooked in that arena. 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. But you can’t compound $100 million or $1 billion at anythingremotely like that rate.

He made a similar comment about size a decade later in 2009: “With tiny sums to invest, it’s extraordinary what you can find. Most of the time, big sums are one hell of an anchor.” It’s not that Buffett can’t find great small-cap stocks, but that these stocks can’t absorb the large amount of capital that Berkshire needs to deploy in order to “move the needle” on Berkshire’s overall performance. So Buffett has to forego the 50% growers and settle for capital-intensive slower growers that can absorb the investment capital he needs to throw at them.

Okay, so the first two criteria for earning 50% annual returns are:

• A portfolio size of $1 million or less; and
• Buy small-cap stocks before they grow up

The third criteria – high return and low capital expenditure requirements — can be found in Buffett’s 2009 shareholder letter on page 9:

In earlier days, 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.

Buffett provides an example of his ideal business on page 7 of the 2007 shareholder letter:

Let’s look at the prototype of a dream business, our own See’s Candy. The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. We bought See’s for $25 million when its pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. Consequently, the company was earning 60% pre-tax on invested capital.

Last year See’s pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire.

http://www.businessweek.com/bwdaily/dnflash/june1999/sw90625.htm

Homespun Wisdom from the “Oracle of Omaha”

What Warren Buffett thinks of stockpicking, the Internet, tech stocks, mergers, Coke, and more 

To prepare this week’s cover story (BRK.A) acquisition, Executive Jet Aviation.

The words of wisdom that follow have been culled from Bianco’s nearly 40 pages of notes taken during his own private conversations with Buffett as well as at speaking engagements and press conferences. Clear themes emerge: Buffett insists on buying businesses he understands. He doesn’t like to sell his holdings. He avoids Internet and technology stocks. And he feels very lucky to be born at a time when his greatest strength — the ability to “allocate capital” — would be so appreciated.

Although Buffett’s experience managing a company with $124 billion in assets is unique, his brand of homespun wisdom can serve all investors evaluating stocks and mutual funds for their own portfolios.

On being a good investor:
“I’m a better businessman because I am an investor and a better investor because I am a businessman. If you have the mentality of both, it aids you in each field.”

“I was born at the right time and place, where the ability to allocate capital really counts. I’m adapted to this society. I won the ovarian lottery. I got the ball that said, ‘capital allocator — United States.'”

“Success in investing doesn’t correlate with I.Q. once you’re above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

On identifying good companies:
“We don’t do due diligence or go out kicking tires. It doesn’t matter. What matters is understanding the competitive dynamics of a business. We can’t be taken by a guy with a sales pitch… What really counts is the presence of a competitive advantage. You want a business with a big castle and a moat around it, and you want that moat to widen over time. Coke and Kodak both had marvelous moats 20 or 25 years ago. Kodak’s has narrowed, while Coke has been building its moat. We want an economic castle.”

“The best thing that happens to us is when a great company gets into temporary trouble… We want to buy them when they’re on the operating table.”

On the size of his stock portfolio:
“If I was running $1 million today, or $10 million for that matter, I’d be fully invested. 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.”

“The universe I can’t play in [i.e., small companies] has become more attractive than the universe I can play in [that of large companies]. I have to look for elephants. It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in.”

On selling stocks:
“I don’t like to sell. We buy everything with the idea that we will hold them forever… That’s the kind of shareholder I want with me in Berkshire. I’ve never had a target price or a target holding period on a stock. And I have enormous reluctance to sell our wholly owned businesses under almost any circumstances.”

“Up until a few years ago, we sold things to buy more because I ran out of money. I had more ideas than money. Now I have more money than ideas.”

On holding cash:
“Today we have $15 billion in cash. Do I like getting 5% on it? No. But I like the $15 billion, and I don’t want to put it in something that’s not going to give it back and then some. The nature of markets is that at times they offer extraordinary values and at other times you have to have the discipline to wait.”

“If you think about it [i.e., the markets], you get these huge swings in valuations. It’s the ideal business arrangement, as long as you don’t go crazy. The 1970s were unbelievable. The world wasn’t going to end, but businesses were being given away. Human nature has not changed. People will always behave in a manic-depressive way over time. They will offer great values to you.”

On the Internet’s impact on business:
“The Internet as a phenomenon is just huge. That much I understand. I just don’t know how to make money at it… I don’t try to profit from the Internet. But I do want to understand the damage it can do to an established business. Our approach is very much profiting from lack of change rather than from change. With Wrigley chewing gum, it’s the lack of change that appeals to me. I don’t think it is going to be hurt by the Internet. That’s the kind of business I like.”

On Internet stock valuations:
“There will be enormous amounts of disappointment. The numbers of people buying these stocks to hold them are very few. I think 98% of them are being bought by people because they are going up. If these stocks stop going up, they’ll get out… Very few of these companies will be big winners in the long run. It’s the nature of capitalism not to get a lot of winners. You get a few.”

“With Coke I can come up with a very rational figure for the cash it will generate in the future. But with the top 10 Internet companies, how much cash will they produce over the next 25 years? If you say you don’t know, then you don’t know what it is worth and you are speculating, not investing. All I know is that I don’t know, and if I don’t know, I don’t invest.”

On technology stocks:
“How do you beat Bobby Fischer? You play him at any game but chess. I try to stay in games where I have an edge such as 바카라, and I never will in technology investing.”

“I do admire the management of Intel and Microsoft, but I don’t have a fix on where they will be in 10 years. I think it is harder to get a fix on those kinds of businesses. I don’t know how to value them. And if I started playing around without knowing how to value a company, I might as well buy lottery tickets.”

On economics:
“I am not a macro guy. I don’t think about it. If Alan Greenspan is whispering in one ear and Bob Rubin in the other, I don’t care at all. I’m watching the businesses.”

“I don’t read economic forecasts. I don’t read the funny papers.”

On mergers:
“I am very skeptical of most big mergers. The assumptions made tend to be very optimistic. People want to do deals — you start with that. There’s a lot of Darwin going on in companies. And people who get to the top want action. I’ve been on 19 boards in my life, and I’d say the great majority of deals that I’ve seen were not very good deals.”

On PaineWebber analyst Alice Schroeder’s research showing that Berkshire Hathaway is selling at a sizable discount:

“I think she did a very thorough job. It seems to me she varied from the standard approach of securities analysts. But I don’t comment on the value. I don’t want anybody to come into Berkshire based on what I’m saying about the value of the stock. Our goal is to have the stock sell as close to the intrinsic value as possible, so that people come in and go out on the same basis.

On Coca-Cola (KO):
“I have a very strong feeling that Coca-Cola will dominate a much larger soft drink business 10 years from now than today. But in terms of the short run, I have no idea what will happen.”

On daytraders and other speculators:
“We try to communicate in a way that turns people off who have a crazy approach to stocks. It matters as much who you repel as who you attract. If we were sizably owned by day traders, we’d have crazy valuations in no time — and in both directions.”

On past mistakes:
“My biggest lost opportunity was probably Freddie Mac. We owned a savings and loan, and that entitled us to buy 1% of Freddie Mac stock when it first came out. We should have bought 100 S&Ls and loaded up on Freddie Mac. What was I doing? I was sucking my thumb.”

“The biggest cause of that kind of mistake [here, failing to buy more Citicorp in 1991], is that I stop buying when the stock starts moving up. I get so enamored of how cheap it was when I started buying that I stop. I have too often folded my tent. I believe in loading up on these things. There wasn’t anyone who thought Citibank was going to disappear. And there wasn’t anyone who thought it wasn’t cheap at $9 a share.”

“We’ve lost very little on errors of commission. The errors of omission are the big ones.”