Geoff Gannon January 25, 2006

What Would Buffett Do?

A while back, there was an interesting post on Shai’s blog about Warren Buffett’s assertion that he could achieve 50% returns on $1 million. This, among other things, got me thinking about how Buffett would invest if he were in the position most of you are. What would he do as an individual investor with a small enough amount of capital to invest that it was really no hindrance?

There are several sources we could use to guess what Buffett would do in your shoes. He has invested some of his own money since taking control of Berkshire, and some of these positions are known publicly. Maybe I don’t watch Buffett closely enough, but I doubt these reports give us a good idea of what Buffett would really do if he were in your shoes.

Buffet ran a partnership before taking control of Berkshire. We could glean something from what’s known about his activities then. But, I don’t think that’s necessarily the best guide either. From what I can tell, the partnership’s holdings were more diversified (in the early years at least) than I suspect a modern Buffett portfolio would be.

I think the right answer is small caps. Buffett’s admitted as much at times. If he didn’t have all that capital to deploy, he’d be looking for the most obviously inefficient pricings – that’s small caps. It has to be. The sheer number of really small publicly traded companies guarantees that’s where the best bargains will be. Small caps are the best place to take advantage of a detailed knowledge of each company. A lot of funds are spread so thin; they can’t have even read all the 10-Ks that well. Several of Buffett’s early purchases seem to echo Graham’s Northern Pipe Line purchase. They involve buying shares in a business for assets that are unrelated (or not necessarily related) to the main line of business. Another similar tactic is buying a business for cash flows (including future working capital reductions) that can be diverted into a more lucrative area (like securities). That’s what led Buffett to Berkshire.

These kinds of opportunities are very rare outside of small cap stocks. If, for instance, a major retailer was, year after year, taking all its free cash flow and using it to buy its leased properties, make early repayments of its mortgages, and buy back stock, people would notice. It would be obvious you weren’t really paying for a business that operates a chain of stores – you were paying for real estate holdings. In small caps, this kind of thing can and does happen. Granted, it doesn’t happen a lot. But, it happens more than enough to create a portfolio based on these kinds of situations.

You really can find businesses that have the majority of their assets in something that isn’t strictly necessary to continue the business. For instance, there are small cap retailers who own almost none of their stores and there are small cap retailers who own almost all of their stores. Some have assets on their books carried in accordance with a transaction that happened last year; others, have assets on their books carried in accordance with a transaction that happened last decade. Even many of the existing shareholders don’t really notice this kind of thing. Maybe they’ve read about it. But, it hasn’t sunk in. They haven’t looked at the value of those assets in relation to the market cap.

In large cap stocks, you basically have to make the opposite bet from the guy on the other side of the trade. In some small cap stocks, you can make an entirely different bet. Even very simple, and very obvious things, like the amount of excess working capital less total liabilities goes unnoticed in some very small stocks. Sure, if net current assets were great enough to exceed the market cap, people would notice. But, when such assets are only enough to give an even greater discount on an already cheap stock, a lot of people don’t notice.

On several occasions, in the past, I’ve bought into a very good (small) company selling at a reasonable multiple, because excess working capital, no debt, and tons of free cash flow made the stock even cheaper than the standard multiples suggested.

One thing I do think Buffett would pay attention to, in small caps just as he does in large caps, is the economics of the industry – specifically, the nature of competition in the industry. But, that doesn’t mean he would only buy world class brands. In large caps, where Buffett has to look, that’s often what he has to do. But, in small caps, it may just mean sticking to industries where everyone can earn a good return on capital and where no one foolish competitor can mess everything up. I’ve mentioned this kind of thing before.

For instance, Energizer Holdings (ENR) is inferior to (the old) Gillette, but that’s okay. In razors and batteries, the number two player can still earn a very nice return on capital. Hasbro (HAS) and Mattel (MAT) may be the dominant toy companies, but that won’t stop a smaller player like Jakks (JAKK) from generating good returns. The same is true in video games. Eventually, there may be four or five large publishers, all smaller than EA (ERTS), and all earning good returns on capital. There’s a difference between video games and airlines. I think you can recognize that without moving to the large cap Buffett extreme of owning Coke (KO).

In large caps, the “hidden” value is going to be mostly intangible. In small caps, it can be a lot more concrete.