- To know a small cap stock in detail and its business environment, you’ll have to invest more of your time than anyone else.
- Investing while following the 20-punch card rule is extremely difficult, even Buffett didn’t follow it.
In a 1999 Businessweek interview, Warren Buffett said the following:
“If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. 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.”
Most investors invest peanuts, Buffett’s measure for $1 million, so they should all be able to make 50% a year. As in life you mostly get what you ask for, why not ask for 50% yearly returns? You might get it.
In this article, we’ll discuss what Buffett meant when he said that, as well as a few strategies you could implement to reach 50% returns.
Size Is A Problem
According to Buffett:
“With tiny sums [to invest], it’s extraordinary what you can find. Most of the time, big sums are one hell of an anchor.”
Small sums allow you to fish for small undervalued companies that have earnings or asset values close to their stock prices. It’s interesting how most financial analysts focus on big names like Apple, Tesla, and Microsoft, while small companies are under-followed or not followed at all. As investors follow analysts, they consequently invest in the stocks they think are the best among those most talked about while rarely or not at all investing in small caps or illiquid stocks, because according to them, those stocks are too risky.
Fortunately for us, analysts that like to dig into smaller undervalued companies know the risk doesn’t come from the business side of the company, but rather from the lack of knowledge about a company, with lack of knowledge really just meaning lack of due diligence.
It’s easy to analyze a company like Microsoft which is dissected by many analysts all over the world. However, analyzing a company that isn’t followed by analysts requires you to learn about the business, sector, company, management, news, etc. This might take a week or more of hard work only to find out that the company isn’t a good investment because there are huge amounts of convertible loans that can be converted in 2022 and will dilute your current ownership by 90%. You can usually only find such information by reading through every annual report the company has issued in the last few years. This kind of intensive research-based investing takes a lot of time, but it is exactly what Buffet does, day in day out. He is reading the financial reports of the companies he is interested in and their competitors.
Buffett’s process for research can be understood from his 1951 Chronicle article The Security I Like Best.
Figure 1: The Security I Like Best. Source: Graham and Doddsville.
In the GEICO case Buffett discusses, he knew the company extremely well as Benjamin Graham was the Chairman, and he understood the trends in the insurance industry where a temporary contraction sent stock prices down while the long-term growth trend was clear, coming from the analysis of data going back 15 years in the past.
I believe today we have a clear advantage over what Buffett had then as we can get to annual reports of any company, big or small, with just a few clicks. When we have identified an undervalued company and understand the business, it’s time to jump in and invest. When things settle, you should be sitting on returns of 50% of more.
Punch Card Investing Rule
Now, business cycles are constant and there is always a sector negatively perceived by the market. This year, commodities hit rock bottom in January, while fertilizers hit their bottom recently. Both sectors gave opportunities for 50% returns.
As an example, let’s discuss Nevsun Resources (NYSE: NSU). In January 2016, NSU fell from a high of almost $4 in 2015 to $2.27. I featured NSU in a report written in January of this year and in an update on the pick sent to Investiv Daily subscribers in August. You can download both the original report and the update here.
What’s interesting is that NSU was cash flow positive at that time, and had $2.15 of cash per share making its business that created the cash free. What’s not too much of a surprise now is NSU’s current price of $3.3, which with dividends included gives you a return of 50%.
However, in order to invest at the right time, you have to be very selective about your investments. Buffett called it the 20 Ticket Punch Card technique, and it allows you to only make 20 investments in your lifetime. I find it the most difficult strategy to adhere to, but it forces you to be selective and enables you to achieve incredible returns. Just imagine the scrutiny you would apply to your investments before investing if you only had 20 slots to fill over your lifetime.
If you invest more than that, don’t worry. In his early days, Buffett owned about 400 securities in 12 years, so there is hope even if you like more action.
The main point of this article is stress the importance of due diligence. When you know more about a stock than anybody else, understand the risks and rewards, and find it severely undervalued, it’s a good time to invest.