Learning the key lessons from the most successful investor of our time is not only smart but required in order to be a successful investor. Although each individual investor has their own MicroCap investments, education in the sector can apply to the sector as a whole. Today I will begin a 38-post internet thread on what we as MicroCap investors can learn from Warren Buffett’s Annual Berkshire Hathaway Letters.

Buffet's work has led to an exhaustible amount of investing books, but their focus on MicroCaps is one that has not been tapped, until now.

Berkshire Hathaway and MicroCap Stocks: 1977 Company Selection

It is easy to get drawn in on Twitter to follow that guy you barely know and his “next big idea”. It is hard enough to find a company worth creating an entire investment thesis about and it is shortsighted to invest based on 140 characters.

“We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price. We ordinarily make no attempt to buy equities for anticipated favorable stock price behavior in the short term. In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price. “

-Warren Buffet 1977 Berkshire Hathaway Shareholder Letter

The phrase “circle of competence” is thrown around a lot and investors should start catching it. The key to investing is staying within that circle and only investing in what you understand. This applies directly to MicroCap investing. Within this realm there is less information available and more assumptions to be made since many MicroCap ventures are in the early stages. These assumptions grow more fractured and unstable when the assumptions are based upon company data that investors simply do not understand.

My advice is not to advise you to pass on a SaaS technology venture simply because you are unsure of how the company’s recurring revenue materializes. Actually, my advice is quite the opposite. Investors should spend considerable time understanding their potential investments before they make a decision. After that, if you cannot grasp it, simply pass on it. I rarely, if ever, invest in financials, basic materials, utilities, biotechnology or pharmaceutical companies.

This was well stated by Mr. Buffett in 1977 when he said “go into a business you can understand”. Understanding the business will help you create a stronger thesis, understand the business changes and industry trends better, and help you hold the company for the long term. Remember, you'll always be smarter passing on a company you don’t understand than buying it.

Moving on, company selection for MicroCap stocks hinges upon Mr. Buffett’s second rule - “invest in companies with favorable long-term prospects”. This is difficult to expand upon due to the highly differential nature between MicroCap ventures but it is much more polarized. Since MicroCaps are in the early stages their timelines are even longer than investing in blue-chip or even small-cap companies. As such, investors need to make conservative assumptions based upon clear data, as small changes in the early stages can magnify and change the outcome, hence the butterfly effect. Whether you are in The Patriot, American Sniper or MicroCap investing, aim small and miss small.

Mr. Buffett’s third point reflects the paramount of MicroCap investing - companies operated by honest and competent people. MicroCap companies are small with only a few people at the helm and, in most cases, a single person’s foot on the gas pedal. Without swift and effective execution by management a MicroCap can fall from heaven faster than gravity allows.

A competent management team can lead to spectacular returns for a company. Investors are urged to reach out to management and speak with them to understand its motives and its motivation. Investors can also backtrack and look at management’s past goals to see if it delivered, and if not, why did it fall short?

MicroCaps do not have the multi-tiered vertical hierarchy of management that larger corporations have. As such, short sighted as well as excellent decisions hinge on a competent management team. Hopefully, this does not sound very bleak. I cannot stress enough the importance in finding a winning management team. It is key to investing in a MicroCap company. As a spin on one of Mr. Buffett’s quotes,

“I would rather buy a fair company with a great management team than a great company with a fair management team.”

Management teams at large corporations can erode or destroy shareholder equity and still have plenty left over for new initiatives. MicroCaps have far less equity and resources to hinge, delegating management as the paramount resource for execution.

Lastly, Mr. Buffett’s investing criteria includes purchasing securities at an attractive price. Of all the hazards with MicroCap investing this is usually a benefit for investors. MicroCap securities are generally undiscovered - granting investors long timelines to accumulate shares before they are put on the map of Wall Street or Main Street. I will save the liquidity argument for another issue (coming soon).

The term “undervalued” can have a few key criteria. Let’s briefly describe two.

It’s far better to look directly at the criteria than to make assumptions. “Buy securities at an attractive price”. As such, investors should attempt to purchase MicroCaps within what they find to be an attractive price. Do not budge for higher prices simply because you feel you are missing out.

Secondly, undue influence should not be placed on financial projections and valuation models on MicroCap stocks. It is better to understand the story since that is the preface to any valuation metrics. As such, make sure a MicroCap company’s share price is not hyped, part of a trading group or ahead of itself. In my experience chances are you are either really early and have plenty of time to accumulate or are late to the company and should pass. You will never make money rushing or being impatient with MicroCap securities.

Note: This is my first, and granted, a quick, educational post on MicroCap securities based on Mr. Buffett’s Annual Letters. I will be looking for feedback and comments before I proceed. If this pans out well future reports will be more in-depth with longer timelines to write.

SecretCaps focuses on extensive and selective research on undiscovered Micro-cap companies. Check out a free-intro of what we do, here.

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Disclosure: This post is only informational, is not investment advice and in the sole opinion of the author. Berkshire Hathaway's shareholder letters were found publicly here, SecretCaps does not own their content, and is citing it as a direct source.