As a small-cap investor, you have a major advantage over every money manager, broker and hedge fund manager in the world. It’s an advantage that gives you the ability to achieve higher returns year after year. It allows you to invest in companies that the greatest investors of all time only wish they could own. And this advantage will never go away for as long as the markets exist.

So what is it? What advantage do you have over famous investors like Seth Klarman (who manages $5.4 billion in assets), Martin Whitman (who manages $6.35 billion) and Warren Buffett (who is sitting on $5.7 billion in free cash)?

Simply put, it’s this: You have far less money than they do.

Sounds ridiculous. Who wouldn’t want the daunting “problem” of having $5 billion in cash to invest with? I know, I know. What a hardship! But when it comes to investing, having billions of dollars is actually a tremendous burden.

The Small-Cap Advantage: $540 Million for 10%

Take Seth Klarman, for example. To nail down just a 10% return for his investors, he would have to earn $540 million. Martin Whitman would have to make $635 million for his Third Avenue Value clients. And Buffett would need to earn a cool $1.1 billion a year before his Berkshire Hathaway investors saw 10%.

I don’t care who you are, making that much money is tough to do — even for the greats. That’s exactly why even the best mutual funds underperform the market by 3.1% each year. And that’s exactly why Warren Buffett told Business Week in 1999, “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.”

That’s a powerful statement from the Oracle of Omaha — one that you should always keep in the back of your mind before doling out thousands of dollars to some fund manager. After all…

When’s the last time you met a fund manager who boasted, “I can make you 3% LESS than the S&P 500″? Probably never. And you never will. But that’s exactly what you can expect when you invest in a mutual fund. And it makes perfect sense.

Large fund managers are limited in what kinds of companies they can invest in. They can’t go out and purchase most tiny small-cap companies — despite the fact they may be growing at a much faster pace than anything else on the market. They can’t go out and buy many of the most fundamentally sound and undervalued companies — those with a tremendous built-in margin of safety. And they can’t invest in stocks that are perceived as “too risky” by their peers and shareholders.

That’s a major problem when you consider about two-thirds of all the companies on the market are small caps — with a market cap of $1 billion or less!

So why are fund managers so limited in their hunt for solid investment opportunities?

First, most small-cap companies aren’t liquid enough for large money managers or investors to get in and out of easily. They simply have too much money to invest. And second, smaller companies are…well…too small to have any meaningful impact on a $5.4 billion fund. For instance…

The best performing stock in the Penny Stock Fortunes portfolio right now is Safeguard Scientifics (SFE:NYSE). It is up 42.55% since it was recommended in October. If you are a PSF reader, you know Safeguard is a good little company. It invests in promising corporations (usually in the biosciences, electronics and technology fields), shores up holes in the business and management side of things and then flips them for a profit through an IPO, merger or acquisition.

Over the last 10 years, SFE has developed 180 firms. Twenty-four have gone public and 40 have been involved in mergers or acquisitions. Not too shabby. But the telltale sign that this company was undervalued and worth owning was the massive insider buying trend.

An executive vice president recently bought 53,000 shares of SFE with his own money. The CEO and a major director each gobbled up another 50,000 shares for themselves. And another insider went hog-wild and bought 190,000 shares.

In the last 12 months, 11 different insiders have bought a total of 427,000 shares in SFE. Talk about a bullish signal! When the officers that run a company put their own money in their business, you should pay attention. It means they think there is some sort of deep intrinsic value that no one else is aware of. And chances are that is a stock that is going to make you some money — which it has.

The Small-Cap Advantage: Do the Math

So why wasn’t every mutual fund in America scrambling to buy this tiny gem?

Well, consider the math. SFE has a market capitalization of $238 million. If the Third Avenue Value Fund — with $6.35 billion in assets — bought the entire company (a very risky thing to do, for a reason I’ll explain in a second), it would have to rise 27% in value to move the entire fund up a single percent. All that money for 1%. Big deal.

But if they are wrong and the stock goes to zero, the shareholders will demand to know what the fund manager was thinking. How could he possibly “waste” their money by investing in a “risky” $200 million company? There aren’t many (if any) fund managers on earth willing to face the wrath of angry shareholders.

Thanks to this constant pressure, most fund managers simply avoid any potential headaches by investing in the same large-cap stocks their peers invest in. They all own Wal-Mart, Microsoft, GE, Procter & Gamble, Intel, Cisco, Google and others. They are happy to create a diverse basket of stocks that perform right with the S&P 500 or the Dow Jones. Heck, they are happy to underperform the market by 3.1%! After all, that’s acceptable in this day and age. And at the end of the year, they can say, “Hey, we finished in the top 1% of our peers! Yeah!”

And if a stock does fall to zero (think Enron), shareholders can’t be too upset. After all, every fund in America owned the stock. So you really can’t blame a fund manager. He just did what everyone else was doing.

Screw that. You can do far better.

As an individual investor, you aren’t restricted by shareholder rules or pressures. You can invest as little or as much as you wish in any company you like. You can buy shares of an illiquid stock and have no fears of getting in or out. And you can take calculated risks — if it means a chance for much bigger rewards. The bottom line is you can invest in any of the 9,000 stocks on the market you wish. And the only person you have to answer to is yourself.

Folks, this is a massive advantage you have over the largest investors on earth. They would kill for the kind of flexibility that you have. In fact, Warren Buffett says it over and over.

His response was: “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.”

He went on to say…

The Small-Cap Advantage: No More Than 200 Stocks

“I know more about business and investing today, but my returns have continued to decline since the ’50s. Money gets to be an anchor on performance. At Berkshire’s size, there would be no more than 200 common stocks in the world that we could invest in if we were running a mutual fund or some other kind of investment business.”

Think about this passage. No, really think about it.

Buffett is limited to 200 stocks in today’s market. That’s it. He has so much money that he can’t even think about touching 98% of the 9,000 stocks on the market — despite the fact that he KNOWS he could make 50% a year on many of them. He even says himself, “Money gets to be an anchor on performance.”

The good news is, as a small investor in this market, you have access to the best of the best. You don’t have an anchor holding you down. You can make 50% a year. You can invest in the stocks Buffett only dreams about.

As a matter of fact, in the upcoming issue of Penny Stock Fortunes, I will feature at least two stocks that have almost no analyst coverage, tremendous balance sheets and the potential to earn you anywhere from 25-200% in profits. And as you probably guessed, they’re way too small for the likes of most fund managers to even touch.

Look for them in the next couple of weeks. Until then, feel free to revel in your lack of money (for now!).

Cheers,

James Boric
December 1, 2005

The Small-Cap Advantage: A Small-Cap Investor’s Biggest Advantage was originally featured in the Penny Sleuth.