Buffett’s Checklist Applied To Small Caps

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Buffett’s Checklist Applied To Small Caps

Recently, I highlighted a passage from Warren Buffett’s annual shareholder letter that reveals how Buffett thinks about attractive investment options. His list detailed six requirements for potential acquisitions, but we focused on one in particular:

Businesses earning good returns on equity (ROE) while employing little or no debt.1

Buffett Primarily Limited to Large Caps

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One of the downsides of Buffett’s success is that his potential acquisition list is mostly limited to lage-cap equities because of the size of Berkshire Hathaway. Buffett has previously addressed this:

We do need to deploy cash, but we can’t put many billions to work every year in spectacular businesses. To move the needle at Berkshire, they have to be big transactions.2

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He also said:

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.3

Getting Diversified Small Cap Exposure That Passes Buffett’s ROE Rule

Warren Buffett is always going to be a master stock picker, but for the rest of us, getting diversified exposure to stocks that have “Buffett” characteristics via an index-based strategy can be a compelling strategy.

Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to “time” market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy. …
The commission of the investment sins listed above is not limited to “the little guy.” Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades.4

If we combine Buffett’s principle of focusing on stocks with high returns on equity and little to no debt with his belief in the “unsophisticated index” approach to investing and apply it to small-cap stocks, I think of the WisdomTree U.S. SmallCap Dividend Growth Fund (DGRS), whose underlying investment strategy selects companies based on their high ROE and high return on assets (ROA) characteristics.

The Dividend Growth Formula: WisdomTree’s Buffett Factor Approach

WisdomTree offers a series of Funds—our “Dividend Growth” family—that employs ROE and ROA as a driving force for stock selection. The reason we included ROA in powering stock selection is that it penalizes the use of debt (leverage) in delivering ROE; therefore, the companies that qualify for our Dividend Growth Funds tend to also employ little debt.

Top 20 Holdings of DGRS

At WisdomTree, we believe that focusing on quality factors, such as high profitability and low leverage, through rules-based processes can be a compelling investment strategy over the long term. We also believe that these are common traits among firms that consistently grow their dividends and have a high potential to increase their dividends in the future. These high-quality, dividend-growing small caps are also selling at attractive valuations compared to broad based small caps, which we think creates a timely opportunity.

1The annual shareholder letter for Berkshire Hathaway, Inc., available here.
2Scott Patterson and Douglas A. Blackmon, “Buffett Bets Big on Railroad,” The Wall Street Journal, 11/4/09.
3Anthony Bianco, “Homespun Wisdom from the ‘Oracle of Omaha,’” Businessweek, 7/5/99.
4The annual shareholder letter for Berkshire Hathaway, Inc., available here.

Important Risks Related to this Article

Diversification does not eliminate the risk of experiencing investment losses.

There are risks associated with investing, including possible loss of principal. Funds focusing their investments on certain sectors and/or smaller companies increase their vulnerability to any single economic or regulatory development. This may result in greater share price volatility. Dividends are not guaranteed and a company currently paying dividends may cease paying dividends at any time. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.

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About WisdomTree WisdomTree launched its first ETFs in June of 2006, and is currently the industry's fifth largest ETF provider. WisdomTree sponsors 69 distinct ETFs that span asset classes and countries around the world. Categories include: U.S. and International Equity, Currency, Fixed Income and Alternatives. WisdomTree pioneered the concept of fundamentally weighted ETFs and active ETFs and is currently an industry leader in both categories. WisdomTree is the only publicly traded asset manager exclusively focused on the ETF industry. WisdomTree is listed on the NASDAQ Global Market under the ticker: WETF.
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1 COMMENT

  1. Here are some actionable investment principles that actually come recommended by Buffett.

    Benjamin Graham – once known as The Dean of Wall Street – was a scholar and financial analyst who mentored legendary investors such as Warren Buffett, William J. Ruane, Irving Kahn and Walter J. Schloss.

    Warren Buffett once wrote a detailed article explaining how Graham’s record of creating exceptional investors (such as Buffett himself) is unquestionable, and how Graham’s principles are everlasting. The article is called “The Superinvestors of Graham-and-Doddsville”.

    Buffett describes Graham’s book – The Intelligent Investor – as “by far the best book about investing ever written” (in its preface).

    Graham’s first recommended strategy – for casual investors – was to invest in Index stocks.
    For more serious investors, Graham recommended three different categories of stocks – Defensive, Enterprising and NCAV – and 17 qualitative and quantitative rules for identifying them.
    For advanced investors, Graham described various “special situations”.

    The first requires almost no analysis, and is easily accomplished today with a good S&P500 Index fund.
    The last requires more than the average level of experience, intuition and talent. Such stocks are not amenable to impartial algorithmic analysis, and require a case-specific approach.

    But Defensive, Enterprising and NCAV stocks can be reliably detected by today’s data-mining software, and offer a great avenue for accurate automated analysis and profitable investment.

    Serenity provides two web-based screeners:
    1. A free Classic Graham screener that lets you screen 5000+ NYSE and NASDAQ stocks by a strict 17-point Benjamin Graham Value Investing assessment.
    2. An Advanced Graham screener (more customizable) that lets you screen the same 5000+ stocks by customized combinations of the Graham Number and Graham’s 15 other Value Investing rules.

    Thank you.

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