“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.”
Warren Buffett — Homespun Wisdom from the “Oracle of Omaha” BusinessWeek – June 5, 1999
When it comes to investing advice, it doesn’t get much better than Warren Buffett. From paperboy to the world’s richest man, Buffett has amassed well over $50 billion dollars in his lifetime. Yet, most people don’t heed his words.
The reason he says that “it’s a huge structural advantage not to have a lot of money” is because the biggest, safest profits are made in Small Cap Value stocks. This is how he made his early fortune. However, once he became rich, it became very hard for him to make money on Small Cap Value stocks.
Here’s why – Properly researching a company often requires over 40 hours (a full working week) of work to estimate its value, risks, and potential rewards. Let’s say Buffet did this with a company like QAD Software (QADA) and bought 10% of the company. If the stock doubled, his after-tax profit would be about $20 million.
Sounds great right? Well, not for him.
From the time that he was a paperboy until he became the world’s richest man, he averaged $20 million per week! During his peak years, that number was probably closer to $100 million. In other words, he couldn’t make enough money in QAD Software to make it worth his time.
This is because he can’t invest enough money in QAD to make a big enough profit (for him). For him, it makes much more sense to research and buy 10% of a $20 billion company that can give him a 25% after-tax profit (10% of $20 billion is $2 billion…and a 25% profit on that is $500 million).
Why Small Cap Value?
Simple. Small Cap Value stocks have outperformed every other class of stock going back to 1926.
Sounds unbelievable, right? Well, it’s true!
A 2009 study is still our favorite work on this subject. It showed that from 1926-2008 the performance of Small Cap Value stocks dominated all others. In fact, Small Cap Value stocks outperformed the S&P 500, returning an average of 13.4% annually (vs. 9.6% for the S&P). This demonstrates a great deal of alpha (basically, the amount of reward an investor receives in exchange for taking a given amount of risk).
The following table shows the return for each category of stock, by decade, from 1958 through 2007:
|Period||Small Cap Value||Small Cap Growth||Large Cap Value||Large Cap Growth|
|1968 – 1977||10.3%||-0.3%||10.2%||1.8%|
|1978 – 1987||22.9%||13.0%||17.4%||13.4%|
|1988 – 1997||20.5%||11.1%||17.8%||18.3%|
The data speaks for itself. We believe that part of this dynamic is explained by the fact that Small Cap Value stocks are often classified as boring or, to use day traders vernacular, pieces of s*** (POS). This is exactly the sort of amateurish negative sentiment that we look for in a stock.
For example, QAD Software (QADA) isn’t an exciting company or stock by any stretch of the imagination. They make old-school software for the manufacturing industry, as they have since 1979. Also, the company has a spotty record of making/missing their numbers. However, if you do your research (or our reports on QAD), you will find a value stock that generates tremendous cash flow, pays a nice dividend, and has built a tremendous amount of sweat equity in its 30+ year existence.
Of course, it requires a great deal of courage to buy a stock that most people would call a “POS”…or does it? Frankly, if you find the facts, you’ll realize that many such stocks aren’t POS stocks after all. They are simply hated, unfollowed, or misunderstood…and this is why the stock price is so low…not because the company is a “POS”.
It should be exhilarating to find and invest in such a company. All you have to do is buy it and wait (FYI, the inability to wait is why most people miss out). This is especially true when your research is backed by individuals with decades of expertise in the topic area.
The naysayers often have none.
Thanks to Warren Buffett’s sage advice, I averaged 40% per year, until my semi-retirement in 2009. Along the way, I have often fallen prey to the allure of a sexy stock…but this is why my returns have “only” been 40% and not the 50% mentioned in Buffet’s quote.