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Welcome to episode 53 of Special Situation Investing where we fast track your investment research with short actionable investment write-ups and insights.
Today we discuss a few of the advantages that come with being a small investor and question why more investors don’t capitalize on those advantages. We will use Warren Buffett’s own investment record to illustrate the differences between the small investor and the large scale institutional investor.
Warren Buffett was in his early thirties and worth well over one million dollars (8-12 million in today’s dollars) before he made a significant investment in a large cap company. His partnership, which in the early 60s, had around seven million in assets under management (56-84 million in today’s dollars) was also invested in small companies and sometimes in companies so small that it acquired them outright. Dempster Mills, Sanborn Maps, and others mark this time period in Buffett’s investment journey.
It wasn’t until his American Express investment in 1964 and his 5% stake in Disney in 1965 that Buffett began to take positions in larger companies but even then his portfolio was skewed towards lesser known businesses with very small market caps.
Imagine for a moment that Mr. Buffett was content being a multi millionaire from Omaha and that he hadn’t gone on to be the worlds richest man or CEO of the largest public conglomerate. In this imaginary world he’s just a rich local guy who by some fortunate twist of fate ends up as your mentor. He takes you out for coffee one Saturday morning and starts to rattle off investing advice that you, of course, copy down just as fast as he can say the words.
My guess is that he’s not going to recommend that you dollar cost average into the S&P 500 index or that you buy the FANG stock dip. I say this because that wouldn’t be consistent with how he’d made his fortune up to that point. Up to that point in his life he’d saved every penny from multiple jobs, used that money to start several small businesses, invested the proceeds in Graham style net-net stocks, and taken fees from a collection of small investing partnerships.
That said, Mr. Buffett would probably recommend that you follow in his footsteps by starting small side businesses, saving every penny, and investing in small, out-of-the-way, no-brainier stocks. You find some out-of-the-way opportunity that no large institutional investor can bother with and you load up such that when it goes up it has a meaningful impact on your net worth.
What I find insightful about this thought experiment is that most small investors don’t apply the lesson. Small investors tend to load up on index funds, or mega cap stocks and as such are self-imposing a handicap on themselves that they don’t need. Warren Buffett is buying Apple and Occidental stock today because only very large companies can absorb the amount of capital he’s working with. Even he would admit that the potential return of some little known micro cap company is far greater than the potential return of Apple.
This is not because the micro cap business is superior to Apple. It could be superior but whether it is or isn’t is not the point. The point is simply this, for a two trillion dollar company like Apple to double your money, its market cap must increase by another two trillion dollars, something that’s possible but highly unlikely. For a company worth fifty million dollars to double your money it only had to increase in market cap by another 50 million dollars. The same basic math holds up for your investment to 10x which would require and added eighteen trillion in market cap for Apple but only 450 million for the small cap stock. To further illustrate the absurdity of a 10x return in Apple stock from today’s 2 trillion market cap consider the fact that US GDP is approximately 22 trillion dollars and that Apples valuation would be nearly on par with the entire US GDP.
Studying 1930-1964 Warren Buffet’s history offers several insights for the small investor that might be missed if we focus on 2022 Warren Buffett. The first lesson was already covered but still warrants another mention before moving on and that lesson is to consider the “runway” remaining for any investment.
As we already discussed with the Apple example, for your one share of Apple stock to double the entire company has to double its market cap, meaning a mega cap company like Apple must grow by trillions of dollars. This means that the remaining runway, or potential for your investment to grow, is very limited for Apple but could be significant for XYZ micro cap that can 10x or even 100x and still not qualify as a large cap company.
Second, a small investor can enter and exit a position much easier than an institutional investor can. Consider the limitations faced by Buffet in terms of entering or exiting a position. When establishing a position he must keep his daily purchase of the stock below a set percentage of the stocks average trading volume. This is to prevent him from biding the stock up against himself and him chasing the stock ever higher as he acquires more.
Buffett, also faces limits on how much of any given stock he can purchase. Above a set percentage of bank stock he must request SEC permission to become a bank holding company. Other public companies have similar thresholds which, once exceeded, require additional permission and public disclosures prior to any further investment.
Exiting a position can be an equally delicate operation for Mr. Buffett as selling too quickly can reduce the price of the stock in the market where selling too slowly can force him to disclose his sale in a 10-Q which signals the market that he’s a net seller of the stock and could prompt others to sell their position ahead of his exit. Selling a large amount of any illiquid position can lower the sale price that the investor realizes but for Buffett a Fortune 500 company could qualify as illiquid.
As a small investor you can easily put 10% of your net worth into a company, even a very small company, and then sell the same company’s stock in a single trade once you’ve realized your target rate of return. This ability is a huge advantage and it should be leveraged whenever possible. Leveraged, but not abused. The flip side of this luxury is the danger of becoming a day trader who disregards sound business principles and timeless investment practices. Remember, the market is there to serve you and not to inform you and you should only move rapidly between investments when you have a well reasoned and sensible reason to do so.
After adopting the perspective presented so far consider its application to your own portfolio. Are you a small investor who’s taking on 2022 Warren Buffett’s handicaps? Do you hold an S&P 500 index, some Google stock, and a bit of Meta to round things out? I can’t guarantee that such a portfolio will underperform or that you’re giving up alpha by holding these stocks, but you’re certainly giving up a universe of high probability investments that you otherwise could take advantage of.
In investing you don’t get extra points just because you made things difficult and finding a home run investment among the largest 50 companies in the world is not improving your odds of outperforming the market. Hopefully, your portfolio is taking maximum advantage of the size and agility advantages that are yours for the taking so that one day your high returns will reward you with Mr. Buffett’s size induced handicaps.
Personally, my portfolio is heavily skewed toward small companies with sometimes very limited trading. Of the ten or so stocks I hold, fully half of them have market caps measured in millions and not billions. The remaining half sit comfortably in the bottom end of the S&P 500 with only one being a top 100 S&P company by market cap. Again, this is no guarantee of future returns but if my investing universe is bigger than Warren Buffett’s I might as well take full advantage of it until that blissful day arrives when size forces me to limit my investment options.
With that we wrap up Episode 53 and as always we’ll be back again soon with another nugget of wisdom or real time investment write up.
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With that thanks again and we’ll see you again soon.
Small investor advantages