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Stepan Lavrouk
Stepan Lavrouk
Articles (623) 

Warren Buffett: The Advantages of Investing in Small Companies

The Berkshire Hathaway chief thinks small businesses provide some of the best opportunities

September 30, 2020 | About:

One of the common knocks on Berkshire Hathaway's (NYSE:BRK.A)(NYSE:BRK.B) Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) is that they haven't been able to match the market-shattering returns of their youth. This is a misguided criticism - Berkshire has such a huge amount of capital that it would be totally unrealistic to expect the company to post high returns. What's more, Berkshire now typically only invests in relatively large companies because it's just not worth their time to invest in smaller businesses - even great ones.

But that doesn't mean that investors with less capital cannot invest in these excellent companies. At the 1995 Berkshire Hathaway annual shareholder meeting, Buffett explained the benefits of investing in small-cap businesses.

A great space for opportunity

Buffett was asked by a shareholder for tips on which small businesses they should invest in. And while he didn't provide any specific names, he did explain why this space can be so lucrative. It's always been true that the small-capitalization space has contained undervalued businesses - it tends to be less followed by analysts, for one thing. Fewer analyst recommendations means fewer institutional investors who will be interested in the business.

Another reason why small companies are often undervalued is that pension funds often cannot invest in them due to the way their mandates are structured. These kinds of institutions are often only really allowed to invest significant sums in assets with low volatility in order to decrease the risk of drawdown for retirees, which rules out many small businesses.

Finally, these companies receive less media attention, which means less attention from retail investors. And as we've seen over the last few months with the smaller tech stocks, retail interest can have a non-negligible effect on stock prices. Here's what Buffett had to say on the matter:

"Clearly you run into companies that are less followed as you get smaller and there's more chances for inefficiency when you're dealing with something where you can buy $100,000 worth of it in a month rather than $100 million."

Buffett's problem is that he is simply too big to buy a small business at a good price. The simple act of a company like Berkshire buying up shares of a small business will bid up the per-share price, which ultimately makes the final price a lot less appealing than it was at the start. I can't say that Buffett doesn't have it pretty good, but sometimes it's better to be small.

Disclosure: The author owns no stocks mentioned.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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