Small-Caps Fit for Buffett

 | May 02, 2013 | 11:00 AM EDT
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Warren Buffett has repeatedly warned Berkshire Hathaway (BRK.A/BRK.B) shareholders that, at the company's present size -- $260 billion and counting -- Berkshire needs "elephant" investments in order for the needle to move. Buffett's assertion is simply mathematical fact: The bigger the denominator, the bigger the numerator needs to be in order for it to make an impact. As a result, Berkshire's investment dollars must go toward mega-cap investments like Wells Fargo (WFC) and IBM (IBM). (This excepts his recent foray back into newspapers.)

Another past Buffett comment that continues to intrigue his ardent followers: He has said that, if he were starting over again, he feels confident that he could earn a 50% return per year. This may sound overconfident, but I really think it goes back to the mathematics again. Buffett is saying that, in the beginning, he was working with much smaller numbers -- so his opportunity set was much wider, because it included small-caps stocks that were less followed by Wall Street and thus more likely to be mispriced.

So if Buffett were buying small-caps today, what would he buy? Obviously we will never know for sure, but here are some names that I think would grab the attention of the Oracle of Omaha: 

Superior Uniform (SGC) is a $70 million maker and seller of uniforms, not the most exciting business in the world. But, to Buffett, boring is good, as it means fewer competitors. Superior Uniform also has zero net debt, trades at a premium to book value and sports a 4.6% dividend yield. This company might not pass the 50%-a-year test, but the business appears solid enough for it not to lose capital. Revenue continues to grow, and the business generates very attractive cash flows. 

Speaking of newspapers, Valassis Communications (VCI) is the leading provider of newspaper and mailbox coupon inserts. The company is using its free cash flow to buy back stock and pay dividends, two things Buffett loves. In addition, Valassis is buying its stock at an attractive price. At $25 a share, the company boasts market capitalization of $982 million, yields at 4.9% and has a return on equity of more than 20%.

Buffett may also take a closer look at Homeowners Choice (HCI), a homeowners insurance provider based in Florida. I've followed this company for years, having recommended it back in October 2011 -- when shares were trading at $8 and yielding at more than 7%. Today, shares trade for $26 and yield 3.5%. But, more important, Homeowners Choice is a superior insurance company. Its book of business is very profitable, and the company has been underwriting profitable insurance for as long as I can remember. Even after the spectacular advance in the share price over the past two years, the strength in housing appears to be another tailwind for HCI. 

As a general rule, the advantage to small-caps is that they get little attention from the investment business community. More fees are made from focusing on a $17 billion debt issuance from Apple (AAPL) or on who is going to take over Dell (DELL). No one cares about newspapers inserts or uniforms. For investors who are trying to grab whatever edge they possibly can, small-caps offer just that.

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