Image Source: PexelsThe “Oracle of Omaha” Warren Buffett is one of the most successful, most popular investors of all time — and for good reason. Following Buffett’s takeover of textile manufacturer Berkshire Hathaway (BRK-A, BRK-B), he’s grown the company into a $1 trillion investment fund. For those who’ve had faith in him since day one, Buffett has delivered a total return of over 3,641,613%.Most amazing of all, Buffett accumulated 99% of his wealth after he turned 65. And the sheer size of his $310 billion investment portfolio provides Buffett with some critical advantages in terms of cutting deals and taking over entire companies.Buffett recently decided to sell some of his Bank of America (BAC) shares — and ended up dumping $1 billion in equity on the market. Shortly before that, Buffett sold off half his company’s position in Apple (AAPL), or 389 million shares worth nearly $6.2 billion.But despite Buffett’s vast fortune and his army of stock analysts, there’s still one critical advantage you and I have over the “Oracle of Omaha.”
The Stocks Warren Buffett Can’t Touch
Nearly a century ago, the SEC established a rule which makes it a real pain for any big investor to buy a certain class of small-cap stocks. If you’re already familiar with small-caps, feel free to skip down to the next section where I talk about this rule in-depth. Otherwise, read on for a quick primer.Stocks are generally categorized by their market capitalizations, or “market cap.” A stock’s market cap is simply its per-share price multiplied by the number of shares it has outstanding.Stocks with a market cap above $10 billion are considered large-cap stocks. $2 billion to $10 billion makes up the mid-cap category. This is the sandbox where the big money plays. $250 million to $2 billion is the “small-cap” space. And companies with market caps under $250 million are called micro-caps.Effectively, the entire micro- and small-cap categories of stock are off-limits to Buffett and his peers. Even when he sees an attractive opportunity there, he knows the size of his investment would be too small to matter — or that he would move the market if he invested a meaningful amount of capital.At the end of the day, Buffett knows he can’t touch small stocks. I doubt he bothers to even look at them these days, because even if he does, he has to “pass.”Of course, Buffett is just the prototypical large institutional investor, and he’s far from the only one. Hundreds of mutual funds, hedge funds, pensions, endowments, and insurance companies face the exact same “size penalty.” They’re too big to invest in the best small-cap companies.Many of those large investors even have rigid rules written into their charters and mandates, absolutely prohibiting them from investing in companies that are too small, either on the basis of market cap or a stock’s per-share price.In fact, one of the “silliest,” yet highly exploitable anomalies related to the size of a stock is what I call “The $5 Rule.”
The Overlooked “$5 Rule”
The $5 Rule dates back to SEC regulation that was written in the 1930s, creating additional hurdles institutional investors must jump through when buying a stock that’s priced below $5 a share.The $5 threshold is, as far as I can tell, completely arbitrary. There is no meaningful difference between a stock that’s priced at $4.99 and one priced at $5.01. Yet, in the eyes of the SEC, and the institutional investors subject to the $5 Rule, there is a difference: $5.01 and above, stocks are “fair game.” $4.99 and below, stocks are effectively “off-limits.”And that’s why I’m saying the little guys like us have a meaningful advantage over the big boys. When we find a high-quality company whose stock trades for less than $5, we can buy it just as easily as a stock that trades for $50.While the stock trades below that threshold, we have little competition from the Wall Street machine and its biggest players. Most institutions won’t touch a stock while it’s under $5. Many analysts don’t even bother covering it. And that leaves a trove of high-quality companies that go overlooked, undiscovered, or untouched — simply because they’re “too small,” according to that arbitrary $5 Rule.And here’s the most beautiful part of it all: once a stock that was previously below $5 crosses above that threshold, Wall Street’s handcuffs are off. Analysts, portfolio managers, and allocators can all jump back in. And when they do, sometimes all at once, it can send prices dramatically higher.At this point, the investor who has read one too many Berkshire Hathaway annual letters may be reading this and thumbing their nose at the risks associated with small-cap stocks. Well, you’re right. Those risks exist. But when you invest the way I do, you know how to mitigate those risks — and find only the small-cap stocks with the highest odds of success.
The Perfect Moment for Small-Cap Investors
It’s clear now that the dramatic shift in Federal Reserve policies and interest rates will have sweeping effects across the market. As the Fed slashes interest rates, borrowing costs will fall in turn. That will provide a much-needed boost to small businesses that rely on debt and financing to propel their growth and help them compete.Indeed, the mega-cap “Magnificent Seven” tech stocks that dominated the market these past two years are already beginning to lag the S&P 500 index, and small-cap stocks have already begun to catapult ahead.More By This Author:The Biggest Risks In Investing In Exchange-Traded FundsWhy Wall Street Gets It Wrong On “High-Risk” InvestmentsTV’s “Mythbusters” Reveal Secret To Nvidia’s AI Dominance
