Today, that same man owns $12.2 billion worth of the Coca Cola Co. Obviously, I’m talking about Warren Buffet…

Everyone already knows all there is to know about him…or so they think…

Sure, we know that he went to Columbia to study under Benjamin Graham. And, that he’s one of the largest owners in many of the brand names we enjoy everyday — General Electric, Anheuser Busch, Bank of America, and of course, Coca Cola. He’s also the wealthiest man in the world, totaling $62 billion.

But there is something that only a handful of people know… He wants to be poor again.

That’s right! Back in 1999, he told BusinessWeek “…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.”

The reason for his guarantee is simple… The best opportunities in the world are in small-caps. If you have a tiny company worth 50 cents per share, it’s a lot easier for it to go to $1, as opposed to a $50 one going to $100. But that’s not the only reason Buffett loves small-caps.

He also discusses his affinity for finding little nuances in companies that other investors don’t see right away. In a 2005 Kansas University interview, Buffett elaborates, “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…”

You can’t do that with big blue chips…

If a small company has a hidden asset that investors haven’t picked up on yet, it would take some work, but you could find it and make big money off of it. Finding a large company with a hidden asset is exponentially tougher.

There are a thousand reasons why smaller companies offer more potential, but at the end of the day, it comes down to one thing. How much more money can I make with small-caps.

Let’s take a look at two charts for a minute:

The top one is Berkshire Hathaway, Buffett’s investment vehicle, from 1977 to 1992. The bottom one is Berkshire from 1992 to 2007.

Upon quick glance, they both look pretty good. In fact, they look nearly identical except the spike at the end of the century, which happened in nearly every single stock traded at the time.

But if you look closer there is a big difference between the two charts. Notice how in the first one, Buffett brought investors gains of 10,000%, and in the second, he only brought a 1,200% gain. Now, I know that still sounds pretty darn good (which it is), but the question remains, why did he do so much better in the first 15-year period of Berkshire than the second 15-year period? The answer is small-caps…

You see, back in 1977, Berkshire was a much smaller company, with a lot less money to invest. So, Buffett was able to invest in smaller companies at the time, including American Express, Disney, and the Washington Post Company… Those companies were able to grow much faster than the ones Buffett is restricted to now. Now, Buffett has to look at companies worth tens of billions of dollars. In ‘77, he could look at companies worth just a few hundred million dollars.

But to do even better than Buffett, your only chance is to look for companies even smaller. I’m talking companies flying way under the radar. Companies in the tens of millions of dollar range… Simply put, buy penny stocks because Warren Buffett can’t.

Sincerely,

Jim Nelson
August 4, 2008

Investing in Small-Caps was originally featured in the Penny Sleuth.

But first let’s understand where “cap” comes from.

When analyzing a company, the most important thing to look at is how much it is worth, or at least how much the market thinks it is worth. That’s called the company’s market capitalization, or “cap.” Here’s how it is figured out…

Say Company X has 100 million shares outstanding and a price of $12 per share. That would give it a market cap of $1.2 billion. The market cap is just the number of shares outstanding multiplied by the cost per share.

But the classification of company sizes is the key idea. For instance, a large-cap (market cap of over $10 billion) cannot grow as much and as fast as a small-cap ($100 million–1.5 billion). Certainly, a microcap (under $100 million) can grow even faster, and a mid-cap ($1.5–10 billion) falls somewhere in between.

[Side note: For our purposes, we’ll combine small- and microcaps… So everything under $1.5 billion will be a small-cap.]

History sides with small-caps. Rolf Banz made a famous study back in the early 1980s, called “The Relationship Between Return and Market Value of Common Stocks.” In this important report, Banz found that over the 50-plus years he studied, the smaller the company, the larger the average return. This held true for all the years he studied, regardless of whether the market ended the year up or down.

Here are the exact results:

As you can see, if you had invested in the smallest companies over that period, you would have made nearly five times what you would have had you invested in the blue chips.

That’s the simplified reason why we love small-caps. So why don’t we call ourselves the Small-Cap Sleuth? Well, we like to break it down even further. Let me explain…

Penny Stocks vs. Small-Caps

Let’s return to our previous example…

Company X has a market cap of $1.2 billion (100 million shares times $12 per share). That’s a small-cap company, but not a penny stock. Penny stocks are defined as anything with a market cap under $1.5 billion (hence, they are all still small-caps) and a price per share under $10. So you can see Company X doesn’t fit both requirements. Therefore, we wouldn’t recommend it.

Now, let’s say Company X has a 2-for-1 split (meaning if you owned one share before the split, you’d own two after). Now there are 200 million shares, but the share price is only $6. That would make it a penny stock. It now falls perfectly within our range.

So why would we recommend only penny stocks? Well, there are a number of factors…

First, there is market psychology at work here…

When certain investors see a $6 stock, they think it’s cheap. This may not be the case. If it had the same market capitalization at $50 per share, the investor wouldn’t think that way. So penny stocks look considerably cheap compared with other small-caps.

That’s one reason. Another is buying power.

With penny stocks, it is far easier to buy more shares as well as diversify between companies. Say you have four companies you’re interested in buying, but only have $100 to spend. If they are all $50 a pop, you can’t do it. Now, if they are all $5 per share, you can get into all of these positions. Thus, buying a diversified portfolio.

The third reason for picking penny stocks over more expensive ones is the price itself.

If a company is sitting at $50 per share, it takes $5 swings to really start seeing profits or losses. With a $5 company, it takes only about 50 cents, which can easily be done in a day of trading. The smaller the price per share, the larger the price swings. That’s how short-term penny stock traders have been making millions over the years.

Whether you are a short-term investor or in it for the long haul, you can see that small-caps, and specifically penny stocks, are the way to go.

The truth is we love small-caps. It’s far easier for a $100 million company to double than it is for a $100 billion one. It’s as simple as that…

Sincerely,

Jim Nelson
June 30, 2008

P.S.: Over the years, many have tried to refute Banz’s study. Critics say that it doesn’t factor in companies that go belly up and fall off major exchanges. There is some merit to this. So instead of blindly picking small-caps to invest in, it’s good to have someone in your corner.

Investing in Small-Caps was originally featured in the Penny Sleuth.

*** If there are any small-cap skeptics left on the planet, just let me say, “Will you please pack it in already?” That’s because the Russell 2000, the benchmark small-cap index, set two back-to-back records this week in a spectacular run-up that still has legs…and I’m talking Lance Armstrong legs.

On Wednesday, the Russell 2000 leapt 0.5%, to reach an all-time high of 609.61. The Penny crew here ran down to James’ office to celebrate. Not only did the Russell 2000 reach nosebleed territory, it was continuing to trounce the Dow Jones industrial average, which closed at 1,333, or 11.4% away from its high, and the S&P 500, which was languishing at 23.9% below its all-time high. Well, we told ourselves, that’s what the fat cats get for following the large-cap pack.

But come Thursday, the Russell 2000 DID IT AGAIN. Yes, incredibly, it hit 616 — a full percentage point higher than Wednesday. And 2 points more than the previous high of 614, set on March 10, 2000.

Given this powerful momentum, small caps may continue to soar through the end of the year. President Bush’s re-election is certainly a factor, since it’s no secret that Wall Street loves him. But a related dynamic is that the war on terrorism will need a full pipeline of innovative technologies to whip the bad guys, and nobody does innovation better than small-cap companies. Entrepreneurs are obsessed with bringing a better mousetrap to market, and when they hit it big, everyone wins…customers, executives and, best of all, shareholders.

*** That’s why I checked in with the vFinance Entrepreneurial Confidence Index (VECI). I originallycovered it in the Oct. 22 issue of Penny Sleuth. The VECI measures where entrepreneurs and venture capitalists are putting their money. For us, it’s a great indicator to determine which small-cap segments will be hot once these startups consider an IPO over the next 12-36 months.

Speaking of setting new records, the October VECI survey was compiled from 3,200 participants, 14.3% more than the previous month’s survey. So which segments made the top of the list? Computer and software services showed the most interest, followed by real estate and leisure.

*** I was talking about the VECI results with Jonathan Kolber, editor of Vantage Point Investment Advisory. Jonathan’s job is to spot the most interesting and inventive small-cap companies you never heard of and show us how to make a mint with them.  Just the kind of entrepreneurs who participate in the VECI surveys.

Jonathan confided in me that in his upcoming issue he’ll profile a company that’s doing landmark work with antioxidants and life extension. His research has uncovered an astounding fact: The company’s discoveries are potentially millions of times more potent than vitamin C. Major university research is showing their supplement can halt, and in some cases reverse, many age-related diseases. It’s even starting to win over skeptical scientists who don’t believe in supplements. This groundbreaking development will mean better health for millions and big profit opportunities for investors. Jonathan is one of the brightest guys I’ve ever met, so check him out:

http://www.agora-inc.com/reports/VPI/288B00

Online Broker Beauty Contest

Two-and-a-half years ago I sold my house in San Francisco for a tidy profit. Not long after, my wife and I moved to beautiful Baltimore — where homes cost a fraction of what they did in the fifth most expensive housing market in the country. So we went from a tiny post-war tract house with spectacular bay views to a 23-room Victorian fixer-upper in a posh historic district. And after the plaster dust cleared, I was able to pocket some money.

Wanting to take advantage of my good fortune, I decided to invest my profits in a few small-cap companies I’d been watching over the last three months. Ready to get started, I called my full-service broker. After chatting for a while (which meant listening to him try to sell me on a new 401(k) plan), I finally got around to telling him which stocks I wanted to buy. That was when I went into shock.

Just to execute a buy order with him was going to cost me $50-250 per transaction. And on top of that, I would have to add several thousand dollars into my account.

I was only interested in buying stocks that were $3 and under…and he wanted how much? Just to break even on my investment, I would have to make at least 20%. I said, “Thanks, I’ll get back to you.”

After that incredible phone call, I decided it was time to dump my full-service broker and look for a cheaper alternative better suited to my new investment strategy.

My first objective was to trade online — cutting out high-priced broker assistance whenever possible. As a small-cap investor like you, I simply COULDN’T afford to pay a ton of money in commissions. I knew that the cost of trading online without broker assistance could reduce commissions by 80% or more compared to my full-service broker…who apparently really enjoyed his filet mignon for lunch.

I also knew that I was going to be holding these stocks for a year or two. I wasn’t looking to trade in and out. So I didn’t need the cheapest commissions on the market. I could afford to pay a bit more in order to get the level of service I wanted.

For instance..

I knew I’d want access to an online portfolio-management feature. I also wanted the ability to trade across a wide range of exchanges. And high-quality broker assistance was an essential backup in case I found myself in a jam.

With that basic criteria in mind, I spent a morning searching the Web for great online broker deals. I came up with a bunch that I thought you’d find helpful in managing your own portfolio of small-cap stocks. If you’ve ever wondered what online brokers are out there, wonder no more. I scoured the Web, and here are the main brokers you need to know about…

*** Ameritrade is one of the most popular online brokers. Online trading commission starts at $10.99. If you need a broker to help you out, the charge could go up to $29.99. The minimum account requirement is $2,000.

Ameritrade is suited for take-charge investors who want to balance low-cost trades with modest resources. You have to be more educated than a beginner, and the professionals available from Ameritrade will expect a modest of level of experience. That means most questions should be confined to using the service itself instead of general questions about the stock market.

If Ameritrade fits your trading profile, this would be a good company to use. (www.ameritrade.com)

*** E*Trade has a commission of $9.99 for active traders under its Power E*Trade service. For customers of its Priority E*Trade service, the commission is $12.99 per trade, plus contract charges that range between $1.25 and $1.50. The commission gets bumped up to $19.99 for Nasdaq, market, limit and stop orders. You’ll also pay an extra penny per share for orders over 5,000 shares. Talking to a broker will cost $45. Other nominal fees vary depending on your account balance.

E*Trade is a full-service online brokerage. Because the company is eager to up-sell services, you can take plenty of time asking about investments of all kinds. Expect E*Trade to be generous with its information. They have a lot of experience in working with new traders. But remember, the company’s ulterior motive is to build the kind of relationship with you that will allow them to provide as many financial services as possible. (www.etrade.com)

*** Investrade’s commission starts at $7.95 per trade. Brokerage assistance costs $10. The minimum balance requirement is $2,000.

Investrade is targeting inexperienced traders who want to move up into a range of other financial services. This site is unique in its educational slant, offering everything from a glossary to an online “course” that is a high-level overview of some options trading theories and terminology. Think of Investrade as a low-cost alternative to E*Trade.(www.investrade.com)

*** Invest.com has a low commission of $4.99 per Internet trade, up to 5,000 shares. If your trade is under 100 shares, there’s a $5 surcharge. Broker assistance costs $12. But to get these low rates, you must have at least $5,000 in your account.

This site is bare bones and highly functional for experienced traders. The company claims that it can keep costs down because it prefers investors who have at least 12 months of investing experience and at least six months of experience using the Internet. (www.invest.com).

*** Charles Schwab’s Schwab Signature Trading package has an entry-level commission of $9.95. That commission applies to online equity trades in eligible accounts once 30 or more qualifying trades are placed in the household per quarter and/or once the household balance reaches $1 million or more.

Hypertraders may want to investigate Schwab’s CyberTrader service. CyberTrader offers special pricing if you trade more than 1,000 trades or 1 million shares per month, but the base rate is also $9.95 plus 0.6 cents per share for the first 2,000 shares and 0.3 cents per share above 2,000 shares (there’s a $1 minimum).

Since Schwab is a full-service broker, the fees vary widely depending on your level of investment with the company. There’s lots of hand-holding here, but you’ll have to ante up for it. (www.schwab.com)

*** Scottrade is another broker noted for its cheap commissions – $7 for an Internet trade plus $1.50 per contract, but at least 75% of your trades must be done online to qualify for that deal. For Nasdaq and listed limit, stop and stop limit orders, add $5. A broker assist costs $17. And you need only $500 in your account.

Scottrade offers a full range of financial services, although its Web site doesn’t provide that same warm level of comfort as, let’s say, Schwab’s.

It’s probably a good idea to be an experienced trader for this service. (www.scottrade.com)

*** XoomTrade’s flat fees start at $5 per trade for the average investor. But there’s also a refundable monthly charge that ranges between $14.99 and $39.99, depending on which of the four services you subscribe to. Each of the service levels addresses increasing volume and sophistication.

If you’re somewhat experienced, XoomTrade sounds like a bargain. (www.pointdirex.com)

The Fine Print

In searching around, I came across a bunch of caveats, exceptions and other fine-print minutiae that you should be aware of before you agree to anything.

If you think you’ll need a lot of tech support, find out if there’s a ceiling on the amount of time you can get before a fee kicks in. And speaking of tech support, it would be very helpful if you knew the specs of your computer…just to make sure that the brokers’ software will run on it without a hitch.

Almost all of these online brokerage services have surcharges for electronic communications networks (ECNs). An ECN is an automated exchange that matches orders between market makers and investors. ECN fees generally range from 2-10 cents per share, but in rare instances, they can be upward of $25 per trade.

I strongly suggest calling the broker before you sign up for its service. Make sure you ask about any hidden fees. And know exactly what services come with the plan you want. If you want to trade after-hours, make sure you are able to. If you know that you’ll be trading large blocks of stock (usually more than 5,000 shares at once), make sure you know about any surcharges for doing so. You may also want to check to see if the online brokerage can execute an order that large.

Remember, it’s your money. So you can ask as many questions as you want. Make sure your broker suits your needs. If it doesn’t, move on.

Happy trading,

Irwin Greenstein

November 12, 2004

P.S. By the way, I ended up going with E*Trade. I had used it a few years ago, and I was happy with the service…and so with that in mind, I settled for a commission that was on the higher end of the spectrum. But as I mentioned, since I was planning on holding the stock for a while, I just thought I’d live with it.

Given that your strategy may be different, you may choose another broker. All of them have responsive sales folks, accessible via toll-free phone numbers, who are happy to answer your questions. Don’t feel pressured to make a decision. Take your time. Choose carefully. And best of luck.

Online Broker Beauty Contest was originally featured in the Penny Sleuth.