Warren Buffett: How to Make 50% a Year in Micro Cap Stocks

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Jan 13, 2011
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A French individual investor, Pierre, who sent in the wonderful CIFE idea, read the post where I mentioned two French micro caps, Precia and Poujoulat, and emailed me this:

“I own Precia shares since several years. I know Poujoulat, I've not invested in it because I think (maybe wrongly) that FCF generation is too low. Anyway, I'm impressed that you were able to find those 2 stocks which are not very well known. How did you do it? Did you use a screener (which one?) Or found them via a blog?”

I wish.

I’d love to have a good screener for French stocks. And I’d love to read a good French value investing blog.

But no. I started with the A’s.

I’m serious about this. And I say it all the time. But most readers seem to think I’m kind of sort of maybe joking a little about working my way alphabetically through an entire stock exchange.

I’m not.

I came to value investing through Ben Graham.

Here’s Walter Schloss on Ben Graham:

“When Ben was operating in the 1930s and 1940s, there were a lot of companies selling below their net working capital. Ben liked these stocks because they were obviously selling for less than they were worth but in most cases, one couldn’t get control of them and so, since they weren’t very profitable, no one wanted them. Most of the companies were controlled by the founders or their relatives and since the 30s was a poor period for business, the stocks remained depressed. What would bring about a change?

1. If the largest controlling stockholder died, the estate may want to sell control.

2. If business got better, then the company would make money.

Notice Walter doesn’t say anything about liquidation. This is a common myth about Ben Graham and net/nets. Ben Graham did not buy net/nets because he thought they would liquidate. Ben Graham bought net/nets because he knew the businesses were selling for less than they were worth.

This is obvious with a private business.

If you put your private business up for sale, there will be no discussion of prices below the net current assets of the business. Private businesses are not bought and sold below their net current assets. So why should pieces of public businesses be bought and sold below their net current assets?

We can take this analogy further by looking at lenders. For over 2,000 years, it’s been pretty easy to borrow against net current assets. The character of the business owner and the quality and future prospects of the business itself have mattered very little to lenders who knew their loans were covered by cash, receivables, and inventories free of other obligations.

If buyers are willing to pay more than net current assets for almost any business regardless of its quality, and bankers are willing to lend up to net current assets for almost any business regardless of its quality, why shouldn’t investors buy pieces of every business selling below its net current assets?

Mostly, they do. Very, very few businesses sell for less than their net current assets. Almost all net/nets are micro caps.

Some people assume that means that there’s something peculiar about net/nets.

They’ve got it backwards. There’s something peculiar about micro caps.

Small stocks tend to be undervalued more often than large stocks.

As a rule: one share of a leading public company sells for very close to the pro-rata price a control buyer would pay for the entire business.

That’s not always true of what Ben Graham called secondary companies:

“The chief practical difference between the defensive and the enterprising investor is that the former limits himself to large and leading companies whereas the latter will buy any stock if his judgment and his technique tell him it is sufficiently attractive…The field of secondary stocks cannot be delimited precisely. It includes perhaps two thousand listed issues and many thousands more of unlisted ones which are not generally recognized as belonging in the category of ‘large and prosperous market leaders’…The intelligent investor can operate successfully in secondary common stocks provided he buys them only on a bargain basis.”

In other words, Graham is saying know-nothing investors should only buy “large and prosperous market leaders”. Know-something investors should buy any stock they want as long as it’s a bargain.

Ben Graham, Walter Schloss, and even Warren Buffett during his best years, all invested almost exclusively in secondary companies. They weren’t all micro caps. But almost none were blue chip stocks.

Warren Buffett made 50% plus returns in micro caps in the 1950s for his own account.

The stocks he invested in were extremely small, and extremely unknown.

A University of Kansas student asked Buffett about this in 2005:

“Question: According to a business week report published in 1999, you were quoted as saying: “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.”…would you say the same thing today?”

Here’s Buffett’s answer:

“Yes, 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/share when it was earning $20/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/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.”

Pin that up on your wall.


There’s a lot in there that’s worth remembering. For instance, Buffett says: “it would perhaps even be easier to make that much money in today’s environment because information is easier to access.”

That’s what I mean about starting with the A’s. Buffett flipped through Moody’s Manuals. I’ve heard some people ask about what’s today’s modern day Moody’s Manual.

It’s the internet.

When I link to a foreign stock, I give you everything Buffett had in a Moody’s manual. I give you the company name (and stock exchange page), the Bloomberg symbol and snapshot, and the company’s annual report archive.

What more do you need?

But, the truth is, a lot of people will get to the place in this article where I’ll link to these pages for CIFE and Precia and Poujoulat and they’ll blow right by them. They won’t follow the links.

French micro caps are just too off the map for most people reading this article.

There’s no reason for that. None of these 3 businesses (roads, chimneys, or scales) are super complicated. Warren Buffett, Ben Graham, and Walter Schloss would at least glance at stocks like these.

Except of course: Warren Buffett, Ben Graham, and Walter Schloss didn’t invest abroad. But, then, they didn’t have the internet either.

We live in a time where information is a lot more heavily digested before it gets to us.

Most individual investors subsist on a steady diet of regurgitated data gruel.

You need to learn to forage if you want to be the next Warren Buffett, Ben Graham, or Walter Schloss.

No one told Ben Graham about Northern Pipe Line. He took the train from New York to Washington just so he could read the government reports.

Today, you don’t have to take the train. All you have to do to is click a mouse.

The difference in returns – for truly enterprising investors – comes from two things. One is attitude. That’s hard to teach.

The other is whether or not you click links like these when you see them:

Compagnie Industrielle et Financiere d'Entreprises (INFE:FP) – Reports

Poujoulat (ALPJT:FP) – Reports

Precia (PREC:FP)

The folks who click those links are going to end up with better returns than the folks who don’t. Not just because those are interesting stocks. You can miss out on any 3 interesting stocks. That’s not the end of the world.

But being the kind of investor who can hear me say: “here are 3 really interesting – not so well known – French micro caps” and then just move on to reading another article instead of clicking those links, someone like that isn’t going to be the next Warren Buffett or Ben Graham or Walter Schloss.

It’s like a kid who does a killer job writing in school, but never sits down at a keyboard outside of school.

That kid is never going to write as well as professional writers.

Ben Graham said investing was most successful when it was most businesslike.

That’s the simple answer to why you should start with the A’s.

It’s the most businesslike thing to do.

If you want to be businesslike about buying stocks, you need to make it your business to know the merchandise. That means looking on your own through foreign and domestic micro caps.

Just to make it clear how ignorant folks are who stick to big caps, I ran a screen on Morningstar to see exactly how much of the merchandise in the stock picking business falls into micro cap territory.

I called anything below $100 million a micro cap.

Morningstar says there are 6,260 domestic U.S. stocks. 2,871 of those are micro caps. That’s 46% of all U.S. stocks.

By ruling out stocks below $100 million, you’re limiting yourself to handicapping just 54% of all races. And you’re playing against probably 90% of professional handicappers.


Wouldn’t you rather bet just the 46% of races that only maybe 10% of professional investors spend their time on?

There’s a lot of talk in academic journals about value effects and size effects. Why do micro caps outperform big caps? Is it just value micro caps that outperform? Things like that.

What I can tell you from my experience – and what Warren Buffett and Ben Graham and Walter Schloss would tell you – is that there are far more obviously undervalued stocks among micro caps. There may be far more obviously overvalued ones too. Does that matter? Are you a growth investor? Are you indexing?

No. You’re a stock picker.

And the best stocks to pick from are secondary stocks. They can be micro caps in the U.S. or overseas. Generally, U.S. stocks of all sizes are more closely followed than foreign stocks of the same size – so it’s easiest to find bargains among foreign micro caps.

And what do I mean by bargains?

You don’t need to focus on just net current assets, or book value, or anything like that. Any appraisal method you use on big caps will work better on micro caps.

Trust me, it’s not like there’s just some strange book value phenomenon surrounding micro caps.

The outperformance of micro cap value stocks can be explained in one word: neglect.

I look for bargains among neglected stocks.

And almost all neglected stocks are micro caps.

If you go around appraising stocks on the basis of their net current assets, book value, enterprise value to EBIT, or enterprise value to free cash flow – trust me, you’ll find the real bargains among micro caps.

My definition of a real bargain is the same as Ben Graham’s. A stock should be selling for at least a 33% discount to what a pessimistic private buyer would pay for the whole business.

Graham liked to use net current assets. But you can apply this rule to any value ratio you like. If you think EV to EBIT is the holy grail of investing and you think 8 times EBIT is what a pessimistic private buyer would normally pay for a business, start by looking at micro caps trading for less than 5 times EBIT.

They’re out there.

In fact, if you clicked the links above, you already found one.

My point is that there’s no isolated low price-to-book phenomenon causing outperformance among micro cap value stocks. There’s a pervasive public value/private value disconnect that infects some micro caps.

It’s been around since Ben Graham’s time. And it means little pieces of micro caps – unlike big caps – sometimes sell for much, much less than a private buyer would pay for the entire business.

All you have to do is turn over rocks – go way off the map as Warren Buffett would say – and then appraise the stocks you find there.

All of this was in the original 1949 edition of Ben Graham’s Intelligent Investor.

That’s where Warren Buffett learned to make 50% a year in micro caps. He read The Intelligent Investor.

And then he applied what he learned to the U.S. stock market of the 1950s.

You have the worldwide stock market to play in. And a Moody’s Manual for every company.

You have the internet.

Follow Geoff at Gannon On Investing