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Mark Gomes, PTT Research (1,259 clicks)
Long/short equity, research analyst, tech, IT channel checks
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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, BusinessWeek: June 5, 1999

When it comes to investing advice, can't seek a better source 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 aren't following in his path.

The reason he believes "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 this class of equity.

Here's why: Properly researching a company often requires over 40 hours (a full work week) of effort to estimate its value, risks, and potential rewards. Let's say Buffett 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 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 showed that small-cap value stocks dominated all others going all the way back to 1926. In fact, small-cap value stocks have outperformed the S&P 500 by nearly 4% annually, returning an average of 13.4% (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

1958 -1967

23.1%

18.9%

18.3%

12.4%

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%

1998 -2007

13.2%

4.3%

9.0%

5.9%

1958 -2007

17.9%

9.2%

14.5%

10.2%

Source: PoisedToTriple.com.

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 even junk (investors often refer to such companies as a "P.O.S."). This is exactly the sort of amateurish negative sentiment that investors should look for in a stock.

For example, QAD Software isn't an exciting company or stock by any stretch of the imagination. The company makes old-school software for the manufacturing industry, as has been the case since 1979. The company has a spotty record of making/missing their numbers, which has kept most investors out of the stock. However, if you do your homework (or peruse our research on QAD), you will find that it is a value stock with a history of generating great cash flow. It also pays a nice dividend and has a loyal customer base, built meticulously over its 30-year-plus existence.

For many, it requires a great deal of courage to buy a stock that most people would call a "P.O.S." However, if you review the facts, you'll realize that the classification is misplaced. Many underpriced stocks get that way because they are underfollowed, or misunderstood. It should be exhilarating to find and invest in such companies. All you have to do is buy and wait (FYI, the inability to wait is why many investors miss out) for everyone else to realize the truth. This is especially true when your research is backed by a company or individuals with decades of expertise in the topic area.

The naysayers often have none.

Source: Becoming A Billionaire Like Buffett