He's been called the best investor of all time. But, why does Warren Buffett wish he had less money to invest? Read on to find out how a small investor like you may have an easier time generating high investment returns than wealthy, investment guru Warren Buffett. (For more on Warren Buffett and his current holdings, check out Coattail Investor.)
The Art of Value Investing
Warren Buffett has perfected the art of value investing. Buffett was a devoted student of Benjamin Graham, who gained fame in the 1920s with his simple investment philosophy of measuring the intrinsic value of a business. According to this strategy, if a company's share price is trading below what it's really worth, he buys it. Buffett looks for companies that are well-managed, with simple, easy-to-understand business models, high profit margins and low debt levels. He then determines what he believes to be the company's growth prospects over the next five or 10 years. If the company's share price today is priced below these future expectations, it usually ends up as a long-term holding in Buffett's portfolio. (Find out how to judge a company by reading, The Hidden Value Of Intangibles.)
Buffett has built Berkshire Hathaway into a $200 billion dollar business. According to an August 2005 paper by Gerald Martin and John Puthenpurackal, Buffett's investment strategy has beaten the Standard & Poor's 500 Index (S&P 500) 20 out of 24 years between 1980 and 2003, and exceeded the average annual return of the S&P 500 by 12.24%. These high returns were not achieved by taking high risk. Berkshire Hathaway's portfolio is comprised mostly of large cap stocks, such as Johnson & Johnson (NYSE:JNJ), Anheuser-Busch (NYSE:BUD) and Kraft Foods (NYSE:KFT). (To learn the difference between large and small cap stocks, see Market Capitalization Defined.)
Compounding is important to Warren Buffett's success. To make his radar screen, a stock investment must have a high likelihood of achieving at least a compound annual earnings growth rate of 10%. When he started four decades ago, Buffett had a wide range of stocks available to him that met or exceeded his minimum return requirement. Back then, however, the size of Buffett's investment portfolio was much more manageable.
Today, being so large and successful is a problem even for Buffett. His challenge lies in how to compound such large sums of money at ever increasing rates. To continue generating high-level compound returns on a massive portfolio, Buffett must take very large positions and only select from the best of large cap stocks. As such, the stocks that meet his threshold have narrowed dramatically.
In mid 2007, for example, Buffett added to his holdings in US Bancorp (NYSE:USB) by 59.1% or almost 14 million shares, but the impact to his portfolio was just 0.74%. He added to his holdings in Sanofi-Aventis (NYSE:SNY) by 326% for a total of 3.5 million shares, but the impact to his portfolio was just 0.18%.
Small Investments, High Returns
During a shareholders meeting in 1999, Warren Buffett lamented that he could generate 50% returns if only he had less money to invest. He couldn't compound $100 million or $1 billion, at a 50% rate. That's because it's the smaller, faster growing companies that typically offer the highest returns. Small capitalization stocks, however, can't help Warren Buffett. For example, if Buffett invested in a $240 million market cap company and its value doubled, the impact would increase Berkshire Hathaway's portfolio by just 0.3%. Considering the amount of research involved, it may not be worth his while. Buffett stays away from small cap stocks, despite their potential for high returns because he neither wants to cause a run up in the price of a small cap stock, nor does he want a controlling stake. (Find out why small caps have more potential for growth, read Small Caps Boast Big Advantages.)
Buffett isn't the only one to become a victim of his own success. Many of the best performing mutual funds and investment portfolios often will close to new investors because they have become too big to handle. Asset bloat makes it harder to achieve the superior returns investors come to expect from funds like these.
For the average investor, it's a real advantage to have smaller sums of money to invest. Thanks to online investing, the proliferation of high performance small cap companies, and the abundance of stocks that can be purchased directly from companies without the need for a broker, such as dividend reinvestment plans (DRIPs) or direct purchase plans, being a small investor has never been easier or more affordable. Small investors can still achieve diversification with limited investment dollars. Do your homework, keep your discipline, pick quality companies and hold for the long-term. If you do, your money will compound rapidly, to the envy of Warren Buffett himself.