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 2017 shareholder letter, Berkshire Hathaway’s (NYSE: BRK-A, BRK-B) investment portfolio of publicly held common stocks has a market value totaling more than $170 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.

Big Gains from Small Caps

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

• A portfolio size of $1 million or less; and

• Small-cap stocks, which often are defined as those companies possessing a market capitalization (i.e., stock price per share times number of shares outstanding) of $2 billion or less.

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 three ingredients often 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 each of the past five years;
• At least $5 of operating cash flow for every $1 of capital expense in each of the past two years; and
• Market cap of less than $2 billion.

The screen yielded five results:

Source: Bloomberg

Would buying these five stocks result in a 50% return over the next year? Only time will tell, because quantitative screens alone are just a first step that must be supplemented with qualitative evaluations of management, as well as sustainability of earnings and market opportunity, to generate a comprehensive investment thesis.

The macroeconomic backdrop, however, sure seems to favor small-cap stocks in the year ahead. During the first quarter of 2019, the profits of small-cap companies in the Russell 2000 Index are forecast to grow almost 16% year-over-year, which is much stronger than the puny 2% profit growth forecast for large-cap companies in the S&P 500 Index.

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