5 Warren Buffett Stocks Dumb Money Should Avoid

There are three types of investors: smart, dumb, and dumber. Eugene Fama is best known for his Efficient Market Hypothesis. His hypothesis helped millions of “dumber” investors to switch to dumb investing. This is widely known as passive investing where you invest in low-cost passive portfolios that mimic the performance of the S&P 500 index or some other broader indices. Academic studies have shown that retail investors, on average, significantly underperform the market after accounting for transaction costs. Switching to passive investing is a big improvement for these investors. However, this doesn’t change the fact that they are still leaving money on the table.

Smart investors don’t imitate the S&P 500 index. There are better ways of investing. Insider Monkey has been touting one of the smart ways of investing in these columns for more than a year now. Our small-cap hedge-fund strategy invests in the 15 most popular small-cap stocks among hedge funds. In our backtests this approach outperformed the market by 18 percentage points per year over a 10-year analysis period. We started sharing the list of these stocks in real time since the end of August 2012. Our picks have returned 70.4% since then, vs. 31.5% gain for the SPDR S&P 500 ETF Trust (NYSEARCA:SPY). Our picks also delivered a return of 48.6% so far in 2013, vs. 28.8% return for SPY. Our main trick is picking the best small-cap picks that are usually ignored by the market participants (see the details here).

Warren Buffett portrait

Investing in small-cap companies is a great way of outperforming the market in the long-term. This doesn’t mean that investors can’t outperform the market by investing in large-cap stocks. It is true that outperforming the market is much more difficult in the large-cap space but it is still possible. Warren Buffett has been claiming publicly for the past 30 years that he can outperform the market. Our research has shown that imitating Warren Buffett’s top-five large-cap stock picks outperformed the market by 30 basis points per month between 1999 and 2012. These stocks also outperformed the market by 37 basis points per month between 2008 and 2012.

Imitating Buffett’s top-five large-cap picks in an IRA account has been a superior alternative to dumb investing. The list of Buffett’s top-five large-cap picks didn’t change dramatically from quarter to quarter, yet it managed to outperform the market by 4 percentage points per year over the past decade or so. Sure, Buffett’s picks can’t beat the market consistently every month or every year. An investment strategy doesn’t have to consistently beat the market to be a better alternative. In general we don’t like investing in large-cap stocks because we know there are better opportunities in the small-cap space. However, if you are interested in only the large-cap stocks, here are five of them that you should consider:

1. Wells Fargo & Co (NYSE:WFC) is Buffett’s largest position in its 13F portfolio. Buffett had more than $19 billion invested in this stock. Donald Yacktman, Tom Russo, and Ken Fisher are among money managers who have big Wells Fargo positions.

2. The Coca-Cola Company (NYSE:KO) is the second largest position in Buffett’s portfolio with $15+ billion at the end of the third quarter. Bill Gates is another mega-billionaire with a huge position in the stock.

3. International Business Machines Corp. (NYSE:IBM) is the third largest position. This is a little bit of a controversial play. Billionaire Stan Druckenmiller has been shorting the stock recently. There are concerns that IBM’s old technology will be replaced by the new cloud technology. This is why IBM trades at very low multiples relative to the market. IBM may also be another example where Buffett manages to pull a rabbit out of his hat and outperforms the market by a large margin.

4. American Express Company (NYSE:AXP) was trading at $10 less than five years ago. Today, it is trading at $85. It may be the best-performing large-cap financial stock over the last five years.

5. The Procter & Gamble Company (NYSE:PG) is the last stock in our list. This is also a very common name that most investors wouldn’t even consider investing. It is not an exciting stock by any means but the stock gained around 40% since Bill Ackman got involved in the summer of 2012.

Disclosure: I am long SPY.

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