3 Stocks Warren Buffett Wishes He Could Own -- But Can't Warren Buffett is a man that needs no introduction. He has amassed a $50 billion fortune over his extraordinary career, and is widely regarded as one of the most successful investors of all time. Naturally, comments like the one below carry a great deal of weight in the investing world. "I think I could make you +50% a year on $1 million. No, I know I could. I guarantee that." -- Warren Buffett, 1999 Business Week. That's a bold claim. A +50% rate of return would double your money in about 20 months, and would turn a modest

If made by anyone else, such wild claims would quickly be dismissed. But Buffett has earned a tremendous amount of credibility and isn't known for making outrageous statements. If the "Oracle of Omaha" says he can earn +50% per year, then most believe he could pull it off. Unfortunately, we'll never know the answer to that question.

You see, Buffett's prediction came with one important stipulation: that he start with an initial investment of $1 million or less. And as the chief of Berkshire Hathaway (NYSE: BRK-A), he is responsible for managing a company with over $100 hundred billion in long-term investments. As you will read below, that huge asset base is actually a major handicap -- one that places heavy restrictions on the type of companies Buffett can buy.

But what if Buffett was starting over from scratch and could freely invest anywhere he liked? What type of companies would he target to generate those +50% annual returns? In today's report, we discover why he would primarily stick to small, undervalued companies. In the process, we'll also provide a detailed look at three such stocks that might have been on Buffett's shopping list.

(1.)  Buffett's Hands are Tied

As we all know, Warren Buffett has consistently trounced the broader market indexes over the past four decades. However, he readily admits that his largest margin of relative outperformance occurred during the 1950s. Beginning in 1956, Buffett's investment partnership racked up an amazing cumulative gain of +1,156% during his first decade as manager, destroying the Dow Jones Industrial Average. But while he has maintained a decided lead, Buffett's edge has narrowed somewhat over the past ten or twenty years.

However, few would say that Buffett has lost his touch. Rather, as Berkshire's assets have ballooned over the past few decades, he has literally had too much money to invest -- which, strange as it sounds, is actually a major disadvantage. Why? Because it essentially means that all but the largest of companies are now off-limits, severely limiting the available pool of stocks that Buffett can invest in.

Consider that Berkshire's investment portfolio is currently worth somewhere in the neighborhood of $100 billion. A few decades ago, an investment of $120 million or so would have represented a meaningful position, and it could have had a big impact on Buffett's portfolio. Today, that amount would represent just one-tenth of one percent of Berkshire's investment holdings. Even if such an investment performed well and gained +100%, it would barely make a dent on the portfolio's total returns.

To have a material impact, a holding needs to represent at least around 1.5% of the total portfolio -- or in this case about $1.5 billion. In other words, for all practical purposes, any company with a market capitalization under $1.5 billion wouldn't be worth the effort for Buffett. And when it comes to Berkshire's portfolio of publicly-traded stocks, Buffett typically looks to establish a minority interest in the target company -- not buy it outright.

Realistically, then, assuming an ownership stake of 10%, if Buffett wants to sink $1.5 billion into a company, then he must target those worth a minimum of $15 billion. And keep in mind, whenever an institutional or other large shareholder acquires a sizeable stake in a company, regulatory documents must be filed and the buy orders must be chopped up to avoid driving the price up. For example, Berkshire's 63-million share position in railroad Burlington Northern (NYSE: BNI), which has an average daily trading volume of 3,100,000 shares, has been made block by block. Again, this forces Buffett to focus on large, highly liquid, and widely-held companies.

A simple stock screen reveals that of more than 10,000 domestic stocks, only a little more than 300 have a market cap in excess of $15 billion. In other words, because of the huge sums of money he must deploy, Buffett can't even consider investing in roughly 97% of all domestic, publicly-traded companies. Instead, he must stick to the giants. And because he has had trouble finding any that meet his strict criteria, Berkshire's cash stockpile has swelled to around $40 billion. That much idle money is far from efficient and drags down investment returns. This is precisely why so many small-cap mutual funds close their doors to new assets once they reach a certain asset level.

Against this handicap, it is a testament to Buffett's financial ingenuity that Berkshire continues to perform well -- the firm's book value increased by $17 billion last year, the most ever for a U.S. company.

(2.)  Good Things Come in Small Packages

Of course, regular investors like you and me aren't responsible for billions in assets. So unlike Buffett, we can nimbly establish positions in tiny companies and still feel the impact when they perform well -- precisely the "structural advantage" that Buffett believes would lead to annual returns of +50%.

Today, Berkshire's portfolio contains huge companies like Wal-Mart (NYSE: WMT). And while the retail giant is an excellent company, it doesn't have anywhere near the upside potential that it once did. This is because stock prices are largely a derivative of earnings growth. And with over $12 billion in annual earnings, Wal-Mart simply can't be expected to post the same type of growth as a smaller company with, say, just $10 million in earnings. Typically, the smaller firm will find it much easier to double or triple its profits -- richly rewarding shareholders in the process.

Of course, the story was far different 27 years ago when Wal-Mart was a young upstart with a promising future. Since then, the stock has skyrocketed about 5,000 times in value, soaring from a split and dividend-adjusted price of $0.01 per share in 1980 to a current price of around $50 -- meaning someone who invested a modest $1,000 would now be a millionaire several times over.

Although only a handful of today's up-and-coming firms will enjoy that type of outlandish success, small-caps are nevertheless fertile ground for investors. As we said above, smaller companies are capable of sustaining higher growth rates, but this is only the beginning. Because most small companies are under-followed and have little Wall Street analyst coverage, there is often only a bare minimum of public information available concerning these firms. In many cases, there are no conference calls, no published earnings estimates, and certainly no Forbes cover articles -- meaning inquiring investors must often pore over recent SEC filings to learn more.

On the bright side, this lack of readily available information keeps many prospective investors on the sidelines, and with relatively few people actively tracking these stocks, they are often thinly traded and can be very inefficiently priced. Therefore, if you are willing to get your hands dirty by digging deeper than others, then the rewards can be well worth the additional effort.

Long-term return data bears this out. According to research firm Ibbotson Associates, small-cap stocks have outperformed large-caps in 22 of the past 35 years. And looking further back, $1,000 invested in large-cap stocks in 1925 would have grown to roughly $2.5 million as of 2005. However, the same amount invested in small companies would now be worth more than $13 million. And this is based on these asset classes as a whole -- just imagine what a hand-picked Buffett portfolio would have done!

Unfortunately, we have no way of knowing exactly which small-cap stocks would catch Buffett's eye. However, it's a safe assumption that regardless of size, he would look for the exact same characteristics that have netted him billions in profits over the years. Specifically, he would be drawn to companies with strong balance sheets, sustainable competitive advantages, attractive business models and industry fundamentals, predictable owner earnings (a variant of free cash flows), and proven managerial teams.

With all of this in mind, we have searched tirelessly for a select handful of small-cap companies that exhibit the same traits that Buffett admires in larger firms. And in the text that follows, we will take a closer look at three standouts that best exemplify the type of companies that have captured his interest and generated huge profits for Berkshire Hathaway shareholders. Although Buffett can't profit from these smaller firms, individual investors certainly can.