2 Small-Cap Stocks Buffett Would Buy

David Goodboy's picture

Friday, June 16, 2017 - 2:30pm

by David Goodboy

His portfolio is built on the largest companies in America. Giants like Apple, Deere, and Walmart dominate his holdings. Thanks to his long-term oriented, value-seeking investment method, Warren Buffett's wealth has catapulted from a mere $6,000 when he was 15 years old to an astounding $73 billion-plus today. 

While Buffett's concentration is on the largest of the large-caps, he has a love for the potential of small-caps, defined as companies with market capitalizations between$300 million to $2 billion. 

A little while ago he told Fortune Magazine, "It's one thing to own stock in a Coca-Cola or something, but when you are actually in the business of making determinations about opening stores and pricing decisions, you learn from it. We have made a lot more money out of See's than shows from the earnings of See's, just by the fact that it has educated me.

How Buffett Picks His Winners
It's safe to say Warren's consultation fee is among the most expensive of all time. People routinely spend a million plus dollars just to have an informal lunch with the guru. Astoundingly, the latest bid posted at $2.7 million for an hour or two of his time. 

But you don't need to shell out the price of a private island to find small-cap stocks Buffett would buy. The investing legend freely provides his investing guidance and strategy to anyone with the gumption to look. 

For almost thirty years, he has written an annual investor letter outlining his ideas for the year, there are multiple books focused on his core philosophy, and Buffett is known to be open about his investing influences in interviews. These sources reveal a few common themes.

Just like "location, location, location" is the mantra for real estate investors, "value, value, the value" could be the three words describing Buffett's investing thesis. Buffett points at Columbia University professors Benjamin Graham and David Dodd as his primary influencers. Specifically, the professors' famous stock market book Security Analysis, which was one of the first works describing value investing.

At its core, value investing is buying cheapened stocks according to an analysis of the balance sheet. Stated simply, shares are purchased at a discount to their actual worth. It doesn't matter if the companies are large-cap or small-cap, his investing thesis remains the same. 

Another crucial concept of Buffett's investing thesis is an economic moat. Moats are especially critical for small-cap stocks, due to the inherent volatility in the small-cap stock sector. Buffett explained the value of a moat in his 2007 Berkshire Hathaway shareholder letter:

"A great business must have an enduring "moat" that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business "castle" that is earning a formidable barrier such as a companies being the low-cost producer or possessing a powerful world-wide brand is essential for sustained success."

2 Small-Cap Stocks Buffett Would Love

1. Maiden Holdings (Nasdaq: MHLD)
Buffett loves insurance companies, and this reinsurance-focused holding company is no exception. Boasting a market cap of $1 billion places it solidly within the small-cap range. 

According to one of Ben Graham's main investment rules, sales cannot be lower than $340 million. Maiden Holdings' sales of $2.7 billion easily fit the criteria.

Maiden also enjoys solid free cash flows and a nearly 2.3% return on assets. A dependable dividend yield of over 5.2% sweetens the shares for value-seeking investors. Add in the fact that the shares are currently trading in the $11.35 zone, near the bottom of their 52-week range, and this stock has value written all over it.

2. Artesian Resources (Nasdaq: ARTNA)
Artesian is a regional utilities provider with a market cap of around $360 million, placing it just above the micro-cap range. The company's 12%-plus profit margin and a dividend yield of over 2% outperform the S&P 500's average stock yield of less than 2% and average profit margin of about 9%.

Utilities are known for wide economic moats due to the extreme difficulty of entry for competitors and government protection. Shares are trading higher by over 30% in the last 52 weeks, adding price momentum to the already bullish metrics. 

Risks To Consider: Small-cap companies are inherently more volatile than their large-cap brethren. Even stable, profitable small-cap stocks can be risky. 

Action To Take: Consider adding one or both of the above small-cap stocks to your portfolio. When evaluating any stock, applying the Buffett value criteria is a time-proven way to improve long-term returns.

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David Goodboy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.