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Warren Buffett’s Advice On How To Make Money With Small Caps

Today, we know Warren Buffett as one of the world’s wealthiest men, who heads a global conglomerate in the form of Berkshire Hathaway. In 2017, this conglomerate reported revenues of just under $350 billion, and nearly 380,000 employees managing just under $720 billion of assets.

It is difficult to believe that this industry champion was at one point a failing textile producer, which was rescued by an up and coming investor, who was relatively unknown at the time.

When he took over the business in the mid-1960s, Buffett’s net wealth was around $8 million, a sizeable sum, but nothing compared to his near $90 billion fortune today.

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Buffett: Building Berkshire

Buffett initially became involved with Berkshire Hathaway in 1962, when he started buying the stock after becoming attracted to its deep value qualities. Like almost all of the other investments Buffett was making at the time, Berkshire was a net-net stock, its market value was less than the value of assets and cash on its balance sheet.

Buying, holding and selling net-net stocks is where Buffett cut his teeth in investing. When he sits out on his own managing the Buffett partnerships, after working with his teacher and mentor Benjamin Graham after leaving college, Buffett made a fortune for himself and his investors buying deep value stocks and holding. More often than not, his patience paid off. From 1957-1969 Buffett Partnership returns were 29.5% per annum, one of the best investment records ever recorded by a hedge fund or investment partnership.

Over the same period, the young investor's net wealth exploded. When he launched his first partnership in 1957 at the age of 27, Buffett's net wealth is estimated to have been around $200,000. When he closed down the investment vehicles, just before his 40th birthday in 1969, he was worth over $30 million.

As the value of assets managed by Berkshire Hathaway has expanded over the years, it has become harder for the Oracle of Omaha to generate the kind of returns he was able to achieve during the first few decades of his investment career. The problem is, Berkshire Hathaway has become too big. Multi-billion dollar opportunities are now required to move the needle. $10 million or even $100 million invested in a small-cap stock that goes onto double or triple might be a fantastic return for some companies, but for Berkshire Hathaway, this would be nothing more than a drop in the ocean.

In some respects, Buffett regrets this success. Its immense size means that Berkshire Hathaway is now no longer able to access the market's best opportunities, those at the bottom end of the investable universe -- where Buffett excels at finding value other investors cannot see.

In a 1999 BusinessWeek report, Buffett was quoted as "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." And in 2005 he was asked to add some color on this statement by a student at the University of Kansas. Here's what he had to say:

"I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts.

It would perhaps even be easier to make that much money in today's environment because information is easier to access. You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map – way off the map. You may find local companies that have nothing wrong with them at all. A company that I found, Western Insurance Securities, was trading for $3 per share when it was earning $20 per share. I tried to buy up as much of it as possible. No one will tell you about these businesses. You have to find them. Other examples: Genesee Valley Gas, public utility trading at a P/E of 2, GEICO, Union Street Railway of New Bedford selling at $30 when $100 per share is sitting in cash, high yield position in 2002.

No one will tell you about these ideas; you have to find them. The answer is still yes today that you can still earn extraordinary returns on smaller amounts of capital. For example, I wouldn't have had to buy issue after issue of different high yield bonds. Having a lot of money to invest forced Berkshire to buy those that were less attractive. With less capital, I could have put all my money into the most attractive issues and really creamed it.

I know more about business and investing today, but my returns have continued to decline since the '50s. Money gets to be an anchor on performance. At Berkshire's size, there would be no more than 200 common stocks in the world that we could invest in if we were running a mutual fund or some other kind of investment business."

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