The Stocks Buffett Wishes He Could Buy

John Del Vecchio is a cheapskate after my own heart.

While he doesn’t mind spending a little cash on the things he enjoys (I won’t tell you how much he and his wife spent on their last vacation), he’s about as hard nosed and tightfisted as it gets when it comes to his investments.

He’s also one of the few truly independent minds I’ve seen in this business. In an industry dominated by herding and groupthink, John is unafraid of taking unpopular or contrary positions, which you’ve probably picked up on in his writing here in The Rich Investor.

Maybe it’s his two decades of experience as a short seller… or maybe it’s because he grew up in upstate New York and has a chip on his shoulder from never seeing the sun. Or maybe it’s a little of both. But I can tell you that John is as independent as they come.

And as an investor, he’s a stone-cold killer that doesn’t blink.

At any rate, John and I were swapping investment ideas at the company Christmas party a few months ago, and I was telling him about some new developments in my trading service Peak Profits, which focuses on small- and mid-cap value and momentum stocks.

Well, that’s about as animated as I’ve ever seen John get (remember, he’s from upstate New York). John told me he was working on a little project of his own that focused on small-cap stocks and, specifically, small-cap stocks priced under $10 per share.

These are two very different things. “Small cap” refers to market capitalization, or the value of all the company’s shares. There is no “official” definition for what constitutes a small cap, but we’re generally talking about companies valued at around $300 million to $2 billion.

But importantly, this had nothing to do with the price per share. A small-cap stock can just as easily have a share price of $5, $50, or $500. It’s not the price of the stock that is relevant but rather the value of the entire company.

Both small-cap stocks and low-priced stocks are good fishing ponds for investors and for essentially the same reason: You’re buying companies that other investors either can’t or won’t touch. It gets back to what I said about John being independent. He’s willing and able to go where others won’t.

I’ll start with low-priced stocks.

These are simply off limits to most large investors. Most institutional investors such as insurance companies, pension funds, endowments and even a lot of mutual funds are forbidden in their mandates from buying stocks priced under $5, as these are considered penny stocks.

But, as a practical matter, most also avoid stocks priced under $10 per share. Smaller shares tend to get whipped around more, and institutional investors don’t want the headache.

Of course, the same institutional investors that wouldn’t touch a stock at $9 per share might suddenly get interested once it trades at $12. So focusing on these lower priced stocks allows you to get in before the big boys.

The story is similar with small-cap stocks. If you run a multi-billion-dollar mutual fund or endowment, you can’t build a meaningful position in a small-cap stock without distorting the market.

We’ll use my hometown as an example. The City of Dallas employee pension plan has about $3.6 billion in assets, making it relatively small as an institutional investor. A 1% allocation would amount to $36 million. You can’t simply go out and buy $36 million of a small-cap stock. That might represent fully 10% of the total shares outstanding.

At that point, you’re no longer a passive investor. You’re likely the largest shareholder and need representation on the board of directors. And even if you somehow managed to get invested without moving the share price higher and managed to avoid the complications of being the effective owner of the company, good luck ever getting out. You couldn’t sell without tanking the share price.

Now, if a small institutional investor like the City of Dallas has this problem, imagine a large institution with hundreds of billions under management. Investing in anything but a mega-cap stock is next to impossible.

Warren Buffett bemoans this fact regularly. The Oracle’s holding company, Berkshire Hathaway, is worth $500 billion, most of which is in publicly-traded stocks. At that size, the investments realistically open to Buffett are limited.

Buffett has repeatedly said that, were he still running a $100 million fund, he could make his investors 50% per year. But at Berkshire’s size, he’s lucky if he beats the S&P 500 by a point or two.

This is the beauty of John’s new project. John’s buying stocks that are off the radar of the big boys. Or, as I like to think of it, buying stocks they’d like to buy but can’t.

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