How “Backdoor Stocks” Gave Warren Buffett His Big Break In Investing
Pity Warren Buffett…
He has billions in the bank. World leaders flying to Nebraska to ask him for advice. And his live comedy show fills a stadium.
But he misses the old days. Before he was the Sage of Omaha and the world’s most loveable billionaire, Buffett was the king of “backdoor stocks”.
Backdoor stocks gave Buffett his big break in investing. They’re a small niche in the market, which can only be accessed by a tiny percentage of investors.
These stocks are a bit riskier than other types of investing, yes. But don’t get me wrong – they’re nothing to do with using options, spread betting or anything like that. They’re basically like investing in regular stocks – except turbo charged.
So what are these backdoor stocks?
Well backdoor stocks are shares in the smallest listed companies on the stock markets.
Think of any company at all that you’d read about in the paper or on the news. Backdoor stocks might be 100th or 1000th the size of those companies.
Investing in the big public companies is like investing “through the front door”. Everybody knows about them, everybody has the opportunity to invest in them, and as a result you can’t expect to make much money from them.
Investing through the backdoor is about investing in companies other investors don’t hear about… companies you won’t see even in the Financial Times or Investor’s Chronicle.
How backdoor stocks work
Here’s Warren Buffet talking about backdoor stocks:
“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.”
He’s saying its much easier to be a private investor managing thousands than professional investor managing billions. Why? Because it’s basically impossible for professional investors to stick their money into small companies.
Warren Buffett manages hundreds of billions of dollars for Berkshire Hathaway. If Buffett were to spot a cracking company on Aim – a retailer worth £20m, say – and if that company were to double in value, it would only increase the size of Berkshire Hathaway’s portfolio by 0.004%.
When you think of the time and effort that goes into finding great companies, it’s not worth it for Buffett to even look at companies that small.
That explains why Buffett can’t buy small companies. But why would he want to?
You surely know this by now, but it bears repeating: small companies grow faster than big ones! Over the last hundred years or so small companies have grown faster than any other asset class.
Why is that? Well, a lot of it comes back to that size thing I just mentioned.
In an efficient stock market, it’s impossible for an investor to get an edge on the market. In an efficient market, stock prices reflect all available information about companies.
Markets get efficient when gangs of hedge fund managers, professional investors and algorithms scour the markets all day every day, looking for the tiniest edge. Professional investors wring the inefficiency out of the big markets like water from a cloth. Even Warren Buffett prefers not to go up against those guys.
Investing through the front door, in other words.
But, as we’ve seen, professional investors have to stay away from small companies. They’re too small to invest in, which means that private investors get the run of the place. There are opportunities just lying around on Aim that you’d never find on the main market.
Here’s Buffett again, talking about his small company glory days:
“When I got out of Columbia the first place I went to work was a five-person brokerage firm with operations in Omaha. It subscribed to Moody’s industrial manual, banks and finance manual and public utilities manual. I went through all those page by page.
“I found a little company called Genesee Valley Gas near Rochester . It had 22,000 shares out. It was a public utility that was earning about $5 per share, and the nice thing about it was you could buy it at $5 per share.
“I found Western Insurance in Fort Scott, Kansas. The price range in Moody’s financial manual…was $12-$20. Earnings were $16 a share. I ran an ad in the Fort Scott paper to buy that stock.
“I found the Union Street Railway, in New Bedford, a bus company. At that time it was selling at about $45 and, as I remember, had $120 a share in cash and no liabilities.”
I want to help you get involved in this little corner of the market. That’s why I’ve been working with a specialist on our new “backdoor stocks” project.
The only catch with this is due to the nature of these ‘backdoor stocks’, we have to strictly limit the number of people we can reveal them to.
That’s why we’re only looking for 160 readers to join us today.