A common question we get: "If Buffett were starting today with one million dollars instead of Berkshire's 1 trillion, what would he buy?" The honest answer is that he would buy small caps. Buffett has said this multiple times across his career, most directly in a 1999 Forbes interview where he noted that "I could make you 50 percent a year on a million dollars" using a small-cap-tilted strategy that Berkshire's size now precludes.
The reason is straightforward: Berkshire cannot meaningfully deploy capital into a 500-million-EUR market-cap company. A 5 percent position would be a 25-million-USD purchase, which is nothing relative to Berkshire's 600-billion-dollar equity portfolio but is also a 5 percent ownership stake in the small company, which is too much for Berkshire to acquire without distorting the price.
For a retail investor with 50,000 EUR to 5 million EUR in capital, the small-cap universe is not just accessible; it is the part of the market where the most inefficient pricing exists. This post walks through the Buffett-style small-cap screen with a worked example.
Why small caps are inefficient
Three structural reasons institutional money cannot fully exploit small-cap pricing:
1. Scale constraints. A 10-billion-dollar fund cannot take a meaningful position in a 500-million-dollar company without becoming a 10+ percent shareholder, triggering filing requirements and reducing flexibility. Most large funds simply do not bother.
2. Coverage gaps. A typical 5-billion-USD-market-cap company has 6-10 sell-side analysts covering it. A typical 500-million-USD company has 0-2 analysts. The sparser the coverage, the more dispersed the pricing.
3. Liquidity penalties. Small caps have wider bid-ask spreads and shallower order books, so institutional flow has higher market impact. This compresses what institutions are willing to pay even for high-quality small caps.
These three forces collectively produce the small-cap value premium that Fama and French documented in their famous 1992 paper and that has been replicated in many subsequent studies (with caveats about how robust the premium is in any given decade).
The 5 filters of a Buffett-style small-cap screen
Translating the broader Buffett framework specifically for small caps requires emphasising certain criteria more than others, because small-cap data is sparser and the risks differ.
Filter 1: ROIC above 15 percent for at least 5 of the last 7 years
The single most important filter. Sustained high ROIC is the fingerprint of a real moat, and the moat is what makes a small cap a candidate for long-term compounding rather than a value trap. Small caps without a moat get competed away within 5-10 years.
The 5-of-7 threshold (rather than 7-of-7) allows for one or two cyclical down years that are forgivable. Below 4-of-7 is a warning.
Filter 2: Net debt below 2.0x EBITDA, with positive net cash preferred
Small caps that fail are usually capital-structure failures, not earnings failures. A small business going through a difficult year can survive if its balance sheet is clean. The same business with 4x EBITDA leverage is fragile.
Net cash position (more cash than debt) is the gold standard. Net debt below 2x EBITDA is acceptable for stable businesses. Above 3x is too risky for small caps regardless of sector.
Filter 3: Insider ownership above 5 percent, ideally above 10 percent
In small caps, insider alignment matters more than at large caps because the insiders have more leverage to influence outcomes. Founder-led companies (founders still own large stakes) tend to produce structurally better long-term returns. Family-controlled European mid-caps (the German Mittelstand style) tend to be patient capital allocators.
Check Form 4 filings (US) or DEF 14A proxy (US) for ownership. In Europe, check the annual report's shareholder structure section or the local equivalent.
Filter 4: Free cash flow margin above 10 percent, stable
Small caps with low FCF margins are easy to disrupt and easy to drown in working capital swings. The 10 percent floor ensures the business has enough margin cushion to absorb a bad year without destruction.
The stability part is important. A business that swung between 20 percent and -5 percent FCF margin over the last 5 years is more fragile than a business steady at 12 percent.
Filter 5: Valuation: PE below 18, or EV/FCF below 15, or owner earnings yield above 5 percent
Small caps deserve a slightly higher valuation discipline than large caps because the structural risks are larger. The thresholds above are roughly 1.5x more conservative than the equivalent large-cap thresholds for the same business quality.
A small cap that passes the first four filters but trades at PE 30 is not a candidate. The discount has to be visible in the price.
Worked example: hypothetical 500M EUR European mid-cap
Consider a hypothetical European specialty industrial business: a 500-million-EUR market cap company that manufactures precision components for industrial automation. Let us call it "PrecisionCo" (not a real ticker; the numbers are illustrative).
Background: family-controlled (founding family owns 38 percent), listed for 22 years, two operating segments, dominant in a niche where it has roughly 35 percent share against fragmented competitors.
Filter 1 (ROIC):
- ROIC last 7 years: 19%, 22%, 21%, 24%, 23%, 14% (down year during COVID), 18%, current 21%
- 7 of 7 above 14%, 5 of 7 above 18%. Pass.
Filter 2 (Leverage):
- Net debt: 35 million EUR
- EBITDA: 80 million EUR
- Net debt / EBITDA: 0.44x. Pass. Well below the 2.0x ceiling.
Filter 3 (Insider ownership):
- Founding family: 38 percent
- Management non-family: 4 percent
- Total insider: 42 percent. Pass. Aligned with shareholders.
Filter 4 (FCF margin):
- Revenue: 320 million EUR
- FCF (TTM): 48 million EUR
- FCF margin: 15 percent
- FCF margin history (5 years): 14%, 16%, 13%, 11%, 15%. Pass. Stable above the 10 percent floor.
Filter 5 (Valuation):
- Market cap: 500 million EUR
- Net income: 38 million EUR
- PE: 13.2 (below 18 threshold). Pass.
- EV: 535 million EUR (market cap + net debt)
- EV / FCF: 11.1 (below 15 threshold). Pass.
- Owner earnings (approximate): 44 million EUR
- Owner earnings yield: 8.8 percent (above 5 percent threshold). Pass.
Result: PrecisionCo passes all 5 filters. It is a candidate for further deep-dive research.
What the deep-dive looks like next
The 5 filters above are screening, not buy-ready. After a stock passes the screen, the actual research begins:
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Read the 10-K equivalent (annual report in Europe). Walk through the business description, segment economics, customer concentration.
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Read the chairman's or CEO's annual letter for the last 5 years. Look for honesty, capital allocation discipline, and consistent strategy.
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Look at the industry structure. Who are the 3 largest competitors? Are they growing faster, slower, or at the same rate as PrecisionCo? Is the addressable market expanding or compressing?
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Run the simplified DCF. See /blog/how-to-do-a-dcf-without-a-finance-degree/. The result tells you the intrinsic value range and how much margin of safety the current price provides.
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Look at insider transactions. Have insiders been net buyers or sellers over the last 12 months? Family-controlled businesses often have minimal insider transactions because the founding family already owns enough.
This deep-dive typically takes 4-8 hours per name. For a retail value investor running a 10-15 stock concentrated portfolio, that is the work that produces returns.
What kills small-cap candidates after the screen
The most common failures, in order of frequency:
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Customer concentration. The screen does not catch this directly. A small cap with 50 percent of revenue from one customer is fragile in a way the financials do not show. Always check the annual report disclosure on top-customer concentration.
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Niche disruption. Some small caps occupy niches that are about to be disrupted by larger competitors or new technology. The historical ROIC looks great; the forward outlook is grim. Industry awareness, not financial-statement awareness, catches this.
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Hidden related-party transactions. In family-controlled businesses, especially outside the US and UK, related-party transactions can extract value. Read the related-party disclosures in the annual report carefully.
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Acquisition-driven growth that masks organic decline. A small cap that grows by acquiring small competitors can hide that the core business is shrinking. Check the organic growth rate (excluding acquisitions) separately.
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Pension or environmental liabilities off the balance sheet. Older industrial small caps can carry off-balance-sheet pension under-funding or environmental remediation obligations that dwarf the equity value. Read the contingent-liabilities footnote.
The temperament challenge
Small-cap investing requires temperament that most retail investors do not have. The volatility is higher. The drawdowns are larger. The liquidity penalty during selling pressure is real. A 5-million-EUR market cap can drop 30 percent on a single quarter of bad results, even if the long-term thesis is intact.
Buffett's framework optimises for businesses you would hold for 10 years through that volatility, not for trading. If you would not hold PrecisionCo through a 30 percent drawdown in a recession, you should not own it through the prior 70 percent rally either.
Where invest-like fits
invest-like covers small caps in our universe (currently 12,500 US-listed equities, with European coverage expanding). The Buffett-Fit Score works identically for small caps; the screening criteria are the same five filters described above, applied to live data.
For small-cap-specific ranking, see /best/quality-composite/ filtered by market cap. For the per-stock breakdown, /buffett/[ticker]/ covers each name in the universe.
For the broader Buffett 5-pillars framework, see /blog/buffett-5-pillars-stock-valuation/. For the 7-framework cross-screen, see /blog/12500-stocks-7-frameworks-cross-framework-consensus/.
Disclosure
Educational tool. "PrecisionCo" is a composite illustration, not a real ticker. Small-cap investing carries structurally higher risk than large-cap investing, including liquidity risk, business-failure risk, and information-asymmetry risk. The 5-filter screen above is a starting point, not a buy recommendation.
Author: Zaid Ghazal, founder of invest-like, Kiel, Germany. Not a registered investment adviser. Full methodology at /methodology/.