For 26 years, I’ve been out there hunting the big yields and bringing them home to my readers.

— Roger Conrad, Big Yield Hunting

Warren Buffett has had a bad week. First, his heir apparent David Sokol was forced to resign because of insider trading allegations involving Berkshire Hathaway’s (NYSE: BRK-A) (NYSE: BRK-B) agreement to acquire cleantech powerhouse Lubrizol (NYSE: LZ). Second, just yesterday legendary hedge fund manager Michael Steinhardt went on CNBC and called Warren Buffett a con artist whom he doubts has actually beaten the S&P 500 on a risk-adjusted basis over time. Steinhardt also said that Buffett’s philanthropy was too late and thoughtlessly performed and his decision to fire Salomon Brothers CEO John Gutfreund back in 1991 was “disgusting.”

I’m pretty sure that Berkshire’s annual meeting on April 30^th won’t be much fun for Buffett either, because shareholders will want to know why, when Sokol told Buffett that he had purchased Lubrizol shares, Buffett didn’t ask him when or how much. And why did Buffett assert that Sokol’s actions were “not in any way unlawful” when they were so clearly unethical at the very least? If Buffett refuses to answer these questions at the annual meeting, he might actually hear some boos for the first time in his life. It now seems that his disappointing Moody’s (NYSE: MCO) testimony last June before the Financial Crisis Inquiry Commission was not an aberration but just an early sign of ethical lapses.

I’m not going to pile on poor old Warren except to say this: all of us small investors can beat Buffett at investing and earn 50% annual returns. No, I’m not talking about making profits from illegal insider trading a la David Sokol – that was so last week. And no, I am not exhibiting the same chutzpah that I accused SEC Accounting Chief Gus Rodriguez of for thinking he knows how to value stocks better than Buffett.

How to Make 50% Per Year in the Stock Market

Rather, what I am talking about is smart investing 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 Buffett’s 2010 shareholder letter (page 6), Berkshire’s investment portfolio of stocks, bonds and cash totals $158 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 anything remotely 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.

Stock Screen for 50% Returns

I think that does it. We now have all of three ingredients needed to generate 50% annual returns. Using my trusty Bloomberg terminal, I ran a stock screen looking for the following criteria:

• Return on invested capital greater than 20% in at least 4 of the past 5 years
• At least $5 of operating cash flow for every $1 of capital expense in each of the past two years
• Market cap less than $3 billion

The screen yielded nine results:

Source: Bloomberg

Would buying these nine stocks result in a 50% return over the next year? With S&P 500 companies growing profits at a record pace, there’s hope for small company growth as well, but only time will tell.

Big Yield Hunting Has an “Income Plus” Investment Philosophy

Small-cap stocks with high returns on invested capital and low capex requirements may generate double-digit annual returns, but they sure don’t pay high dividends. For double-digit yields, check out Big Yield Hunting, the high-yield investment service from Roger Conrad and David Dittman. Roger and David take an “income plus” approach to their recommendations. High yield alone is not enough; they demand high yield “plus” a healthy and growing business:

High yields without strong businesses behind them will be at perpetual risk of devastating dividend cuts. And they have no chance of growing either, so they’re guaranteed losers if inflation emerges.

In contrast, only growing and healthy companies will continue to pay their distributions. If we see more inflation, growth is our best chance of keeping pace. Adopting an “income-plus” strategy won’t save your portfolio from all volatility if credit or inflation conditions worsen. But it remains the best approach.

An “income plus” investment standard disqualifies many high-yield companies from Roger and David’s consideration. So far, Big Yield Hunting has recommended two Canadian income trusts, three telecommunications companies, a master limited partnership (MLP), and a fascinating stock/bond hybrid security. All of these top-notch stocks sport very high yields that are stable and sustainable.

Give Big Yield Hunting a try today!