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Micro Caps and Buffett's >50% returns


rukawa
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Buffett has stated several times that he could make >50% returns if he was till investing small sums of money. His largest returns ever were pre-partnership and early partnership in the 1950's using what was basically a pure Graham approach with Micro Cap stocks. The obvious question is why can't this be done today? Buffett would read Moody's manuals, the modern equivalents are ValueLine and Mergent online. My view is that if I am going to invest I ought to invest where I have a decisive competitive advantage over fund managers, institutional investors and others. Also where I can get the highest returns. Small Caps are known to have higher returns. And most fund managers cannot waste time with Micro Caps because the sums of money they manage are too large. So until I become a billionaire investing huge sums of money it makes sense for me to focus on Micro Caps.

 

I have also read OddballStock's website and some of his postings. He adds another reason which is that Small Caps are easier to understand since their businesses are relatively uncomplicated.

 

I am looking to generate a debate about this. What are the pitfalls of investing in this area. Why do people avoid this area? For the posters who are investing in this area what approach do you use. How do you find these stocks and investigate them. OddBallStocks, I know this is your specialty so I would appreciate any advice you have, tips, pointers, argument etc.

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Pitfalls are simply that they are not great businesses. They may have bad management, questionable business models, poor growth prospects etc etc.

 

I'm not making a case against investing in this sector. But I think the opportunity is overblown about a romanticized idea of investing in securities no one knows about. I'm also skeptical that returns are really that high once you take into account the ridiculous volatility some of them have. I'm looking at a sub-2M company, and it moves like 10-20% at any given day.

 

I think one can do well investing in these, but I question the notion that it is a "shortcut" to putting up great returns.

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You can find value in small caps but you have to make sure it is not trapped by management or controlling shareholders.  Look at ITEX and Western Sizzlin as an examples.  Good companies that many on this board have invested but had governance issues. 

 

I personally like the small cap area (let say mkt cap greater than $50m up to a few hundred million) unless I really know and trust management.  Also in this larger space most of the companies if they are poorly run can have enough investors oust the current management, like what is going on the SD right now. 

 

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I think micro caps can be a rewarding area to invest in and a lot more stocks look undervalued, but there is usually a reason why they are cheap (bad business model, shareholder unfriendly management, poor operations, etc).

 

Ballantyne (BTN) is a micro cap company that I have looked at before with a lot of cash. When the company announced a stock buyback, it went from $3 a share to over $6.  After the most recent quarterly miss in earnings and talk from management about acquisitions, the stock is now down to $3.50 a share again.

 

 

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You have to be careful on how you use the small cap data.  Look at the performance of the DFA small cap value fund to get a better idea of real performance.  The stocks that are small have large bid-ask spreads that can distort the data you also have the survivability bias in the data.

 

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They may have bad management, questionable business models, poor growth prospects etc etc.

 

True they could have these qualities. But is there then no price whatsoever that would tempt you to invest in them?

 

But I think the opportunity is overblown about a romanticized idea of investing in securities no one knows about. I'm also skeptical that returns are really that high once you take into account the ridiculous volatility some of them have.

 

50% returns are probably extremely difficult to achieve. But can higher returns be achieved? Check out table 6 of What has Worked in Investing. The highest returns are achieved by small cap value, in particular the 10th decile of both P/B and Market Cap simultaneously. The returns are 23% from 1963-1990 for this group of stocks. That means a purely passive small cap value investor would have grown $100,000 to about $24,000,000 over 26.5 years.  Generally the out performance is about 10% PA over Large Cap Value.

 

You have to be careful on how you use the small cap data.  Look at the performance of the DFA small cap value fund to get a better idea of real performance.  The stocks that are small have large bid-ask spreads that can distort the data you also have the survivability bias in the data.

 

I remember looking at DFA over its life-time because I wanted to compare DFA with Francis Chou. I believe that passive Small Cap Value actually beat Chou. The returns were however a lot smaller than 23% over the period. I think both achieved returns around 11 %. Of course the time periods for the Fama study and DFA are not the same so results are not comparable.

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They may have bad management, questionable business models, poor growth prospects etc etc.

 

True they could have these qualities. But is there then no price whatsoever that would tempt you to invest in them?

 

 

I did not say there was no price whatsoever. I just mentioned a pitfall as you had noted, "What are some pitfalls?".

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I think that he would try to invest mostly in great businesses with fair prices as opposed to cigar butts.

 

Even in his partnership days, he invested in American Express (which at one point was his largest position)... so I don't think that he would restrict himself to microcaps.

 

I have no idea if he would invest in LEAPs or other options.  Certainly nowadays Warren owns warrants, has sold puts on BNI, has written put option contracts linked to equity indexes, etc.

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There's a video on neatvalue.com about this, and Buffett answers the question, he said if he were managing less than $10m he would be buying the classic Graham stocks, the low book value and less than working value stocks.

 

http://www.neatvalue.com/2012/05/one-of-best-bargains-i-stumbled-upon-in.html

 

So from the mouth of the man himself, buy enough really cheap stocks and it's almost impossible to go wrong.  He's obviously changed as his assets have grown, which he states himself.

 

I appreciate the shout-out OP, and I want to say that micro-caps aren't the only area of opportunity.  Small caps abroad are priced strangely as well, and often times foreign small caps have much bigger market caps than the US stocks.  So if market cap makes you comfortable I'd say go abroad.

 

As for bad corporate governance you find that in all sized companies.  Yes there is egregious pay at small companies, but there's gross egregious pay practices at large companies as well.  As yourself, does any CEO deserve $10m a year, or $100m a year in pay?  Forget market cap, most management will steal from shareholders when given the opportunity.  Maybe this is my American always watch out for being back stabbed sense talking, but it's been my observation.  There are many micro-caps where management treats shareholders like fellow partners, and in some cases like family, at a level I've never seen in a bigger company.

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I think that he would try to invest mostly in great businesses with fair prices as opposed to cigar butts.  Even in his partnership days, he invested in American Express (which at one point was his largest position)... so I don't think that he would restrict himself to microcaps.

 

American Express was late into the partnership, 1960's. Buffet's >50% returns were during the 1950's which was mostly pre-partnership when he was working from Graham. This was the time where he read through all 20000 pages of the Moody's manuals twice. His style at this point was pure Graham.

 

I think you would be surprised as to the type of things Warren investing in even after the partnership started. From SnowBall:

 

"In his personal portfolio, he still played with things like the "penny" uranium stocks...These were now fantasically cheap....it was shooting fish in a barrel. They weren't large fish, but you were shooting them in a barrel. You know you were going to make good money. It was minor. The bigger stuff I was putting in the partnerships"

 

There is however one non-Graham stock that Warren did invest in as did Graham...GEICO. So your right that he wouldn't totally restrict himself.

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I can't imagine deals like that ever occurring again.  Too many people are looking at micro-caps.  The market has certainly become more efficient since graham.  Companies selling at less than 1x earnings?!  unreal!

 

They'll occur...especially when markets are extremely volatile, because the psychology has not changed.  If you remember what things were like in late 2008 and early 2009, most value investors were out of the market and analysts were wringing their hands because they didn't even have time to adjust target prices as stocks fell. 

 

How many people bought GE at $6 or WFC at $9?  How many bought BAC at $5 a little while ago.  I remember no one was buying SHLD short-term debt...maturing in just over a year and it was trading at 65 cents on the dollar! 

 

With more attention and more eyes on the markets, plus all sorts of dark pools of capital, I think we've actually compressed time frames and you get far more inefficiencies in prices.  The one area where there are truly fewer opportunities is arbitrage where computerized trading has just been able to exploit it to their advantage.  Cheers!

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His style at this point was pure Graham.

I don't think it was... at least, that's what I got out of reading The Snowball and Tap Dancing to Work.

 

Buffett did do some things differently from Graham.  Tap Dancing to Work discusses how it took a long time for Buffett to really learn his lesson about buying great companies.  Berkshire Hathaway was his biggest mistake.

 

There's a video on neatvalue.com about this, and Buffett answers the question, he said if he were managing less than $10m he would be buying the classic Graham stocks, the low book value and less than working value stocks.

 

http://www.neatvalue.com/2012/05/one-of-best-bargains-i-stumbled-upon-in.html

Watching that video... the question is a bit leading but Warren starts to mention how he'd buy stocks that Graham wouldn't.

 

I think that Buffett would have most of his portfolio in concentrated positions in great businesses rather than lots of small positions in cigar butt stocks.  If he had to do things over, I think he would own more great businesses (e.g. GEICO, see's candies) and less cigar butts.

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I can't imagine deals like that ever occurring again.  Too many people are looking at micro-caps.  The market has certainly become more efficient since graham.  Companies selling at less than 1x earnings?!  unreal!

 

The market is generally more efficient now than then, but there are also more opportunities available without having to dig through illiquid securities.  Simply by identifying small profit situations that are nearly sure things and levering up with non recourse leverage, one of the smaller accounts we manage has increased in value more than five times in the last several months, other, larger accounts, not so much.  :)

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I can't imagine deals like that ever occurring again.  Too many people are looking at micro-caps.  The market has certainly become more efficient since graham.  Companies selling at less than 1x earnings?!  unreal!

 

They'll occur...especially when markets are extremely volatile, because the psychology has not changed.  If you remember what things were like in late 2008 and early 2009, most value investors were out of the market and analysts were wringing their hands because they didn't even have time to adjust target prices as stocks fell. 

 

How many people bought GE at $6 or WFC at $9?  How many bought BAC at $5 a little while ago.  I remember no one was buying SHLD short-term debt...maturing in just over a year and it was trading at 65 cents on the dollar! 

 

With more attention and more eyes on the markets, plus all sorts of dark pools of capital, I think we've actually compressed time frames and you get far more inefficiencies in prices. The one area where there are truly fewer opportunities is arbitrage where computerized trading has just been able to exploit it to their advantage.  Cheers!

 

This is precisely the key argument against the case for small caps being under followed and thus inefficiently priced..... The more Wall Street clowns looking at BAC or any other large stocks, the more likely the stock price will reflect the emotional bias present in almost every Street conclusion.

 

With Street research you get a double whammy (in a good way!) - tons of information on companies and industries at very little cost, and inefficiently priced stocks due to short time horizons!

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Doesn't anyone think that Buffett is exaggerating a little when he says he can do >50% returns? He might have made >50% returns for a couple of years for say the Korean stocks, but I highly doubt he can replicate it over say a 10+ year holding period. Even during his early partnership days he made 30% odd compounded, and that was during the time when there seemed to be a lot more bargains and the crisis seemed worse like during 1973.

 

Let's say Buffett were to do this all over again. He might be picking Graham-like stocks when handling lesser sums of money but again I think he would be making around 30% compounded or less. We also know that people like Ted Wechsler and Charlie Munger can make 20+% compounded by concentrating on great companies but not at dirt cheap price. Wouldn't it not make much of a difference in terms of returns whether you choose the Graham or the Munger style? Furthermore you would need to know when to sell when using the Graham method as you can see some of the investments Buffett made in his partnership days actually went into bankruptcy or below his costs but he sold it before that happened.

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benncycx

 

at the end of the day no one knows (this is just my opinion and yours), from knowing what buffets says and does i don't think he was exaggerating about his statement that he can do 50%+ if he manage small amount of money (also remember he never said when he will stop guarantee making 50%+)

 

when was the last time buffett exaggerated about some sort of performance # (nothing that i am aware of) let alone about something that he would do, let alone saying "he guarantee it"

 

to say he didn't do it in his early days so he can't possible do it is a bit simple. I am sure buffett as a investor now is miles ahead of that guy back in the 50's

 

also buffett rarely make statement like this, something along similar lines was back in 2008 or was it 2009 when WFC was in the 9's.

 

he said very frankly unambiguesly, he would put ALL his money into WFC at 9's if he could. when i hear that i was shocked, because he rarely make statement like that in REAL TIME as it happens.

 

Rarely make statement of these types

 

ALSO not to put ERICOPOLY down, but i am sure if you ask eric his compounded performance is prob over 50%, if not very close. NOW if someone on this board can achieve it, you think one of the best investor ever can't?!

 

 

EDIT: honestly buffet knowing him prob has already done it in his personal portfolio

 

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Don't get me wrong I'm not saying that >50% is impossible. I'm saying the 50% compounded is possible maybe for 2-3 years but not over say 10++ years. In fact I'm sure alot of people including me on this board has 50% compounded over the past 2 years or so because of BAC and what not.

 

Again let's say WFC at 9s. Well yes let's say he put everything into WFC he would have gotten something like 300% or something, but then what now? That is 50% compounded for 3-4 years but can it continue? He would have to dump Wells now at $30 and then put it into another Wells like situation again like BAC at $5 or something, and repeatedly do that to get >50% continuously.

 

Not sure if I can buy the argument that Buffett is "miles" ahead now. If that were the case, we would see that all investors have exponential returns as they age. It seems that through the years Buffett's philosophy has changed to a Munger like style and looking for great companies which wouldn't really help increasing returns to 50%. What is more likely happening is reversion to mean and that his returns in his partnership days were good but also an "outlier" - the Malcolm Gladwell argument

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benncycx

 

at the end of the day no one knows (this is just my opinion and yours), from knowing what buffets says and does i don't think he was exaggerating about his statement that he can do 50%+ if he manage small amount of money (also remember he never said when he will stop guarantee making 50%+)

 

when was the last time buffett exaggerated about some sort of performance # (nothing that i am aware of) let alone about something that he would do, let alone saying "he guarantee it"

 

to say he didn't do it in his early days so he can't possible do it is a bit simple. I am sure buffett as a investor now is miles ahead of that guy back in the 50's

 

also buffett rarely make statement like this, something along similar lines was back in 2008 or was it 2009 when WFC was in the 9's.

 

he said very frankly unambiguesly, he would put ALL his money into WFC at 9's if he could. when i hear that i was shocked, because he rarely make statement like that in REAL TIME as it happens.

 

Rarely make statement of these types

 

ALSO not to put ERICOPOLY down, but i am sure if you ask eric his compounded performance is prob over 50%, if not very close. NOW if someone on this board can achieve it, you think one of the best investor ever can't?!

 

 

EDIT: honestly buffet knowing him prob has already done it in his personal portfolio

 

it's not just about pure performance. it's about risk adjusted performance over long periods of time. long enough to test performance. so you get all the guys together who are compounding at very high rates and you look and you examine their records and tally up performance.  and then you figure out HOW they are doing it. I bet you would discover that partnership days Buffett compounds at very high rates in a less risky way than other high compounders do. defining "risky" as the probability of losing your money. jmo.

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The biggest issue is defining risk a-priori.  It is easy to see the risk of the past but harder to see it in the future.  If you are a value investor it is even worse.  Is buying a cheap asset with LT non-recourse leverage more risky than an awesome asset at a fair price?  I depends upon how the asset is priced in the future which we do not know a-priori.  The issue is price and risk are related (as the price of an asset declines so does its risk).  So all we can do is buy cheap assets and if available use cheap leverage to purchase them if they are really cheap.

 

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From things I have heard in the recent past about Buffett's personal portfolio, I believe he could do 50% a year...with small sums as he stated...but it would not take long for it to be well above that threshold and the impact of size would start to affect results. 

 

So if Buffett could start again now with $1M, which is what he was discussing when he made that statement, I think he could compound at 50% a year for about 12, maybe 15 years...which would get him close to half a billion...I think 15 would be pushing it.  From there I think you would see diminishing returns as the number of opportunities decreases.  Cheers!

 

 

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i guess the quesiton are

 

1. can 50%+ be done (i think we all agree it can)

 

2. how long can it be sustain (who knows 5, 10, 15 yrs?)

 

3. what type of investment - this is where it gets interesting. i think you can achieve the 50%+ with all kinds/type of investments (small, big, special situation, micro cap whatever). In addition to the type of investment (i honestly it can be done with all kinds of stuff), another important question is what you do with the investment.

 

for me personally i have tons of sock in retrospect can use to achieve 50%+, its a matter of how  many share bought, how long it was held, when it was bought/sold, was leverage use (options etc) etc.

 

so i guess what i am getting at is, its not just the type of investment (small cap, large cap) there are many other things like how concentrate are you, what you did with the investment, was leverage use etc etc.

 

 

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That is very interesting because a lot of small or micro cap stocks from Nate at oddball or VIC do indeed get 50% returns, but the problem is many of these stocks are essentially "value traps" even though they may not seem to be so a priori. I think Buffett's main method in achieving the high returns would be to find these small stocks but at the same time concentrate on the good ones and avoid the value traps.

 

In other words, being a value stock is not enough. It has to be the Absolute value stock. :)

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