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Dreadful Stocks to Avoid
Warren Buffett's first rule of investing is: "Never lose money." To this, he often adds rule No. 2: "Never forget rule No. 1." Of course, following these rules is easier said than done.
I take those rules to heart in my investment strategy. I try to focus my investment dollars on sustainable, undervalued businesses that I can easily understand. Buffett has made more than $40 billion for himself using that strategy, and he's made even more for his partners and shareholders over the years. Do you really need to assume a lot of risk to make more than $40 billion?
People spend a lot of time discussing the companies Buffett buys. But in the spirit of not losing money, it's equally worthwhile to understand the types of businesses that Buffett does not buy in order to steer clear of potential duds. I see five main categories:
1. Businesses that bet the farm
In some industries, companies occasionally have to make critically important decisions. If the company makes the wrong choice, it will be dealt a crippling blow. This is terrible for a shareholder, because even if the company makes the right decision one month, it might fail to do so the next. There's no "three strikes and you're out" policy. One strike, and it's game over -- your money's gone.
2. Businesses dependent on research
It's quite reasonable to believe that research can be a competitive advantage for certain companies. Nevertheless, there is a downside to research. Often, innovative companies are required to do research simply to maintain their competitive position. And if the research dries up, the company suffers.
While I don't think this is sufficient reason to sell off all your tech or biotech stocks, I can understand why Buffett avoids such investments.
3. Debt-burdened companies
In general, Buffett avoids companies with a lot of debt. This makes sense. During the best of times, large amounts of debt mean that cash that could be put toward growing the business or rewarding shareholders is instead servicing the debt. In a crisis, debt greatly limits a company's options and can sometimes lead to bankruptcy.
A more subtle point is that great businesses throw off piles of cash. Great businesses generally don't need to use huge amounts of debt leverage to achieve an acceptable return for shareholders. So, if a company needs debt to achieve reasonable returns, it's less likely to be a great business.
4. Companies with questionable management
Management has incredible power. If executives want to enrich themselves at the expense of shareholders, either directly or by misrepresenting the company's prospects, individual shareholders have almost no hope of stopping them. I strongly recommend avoiding companies where there's even a hint that management lacks integrity. That's why I think questionable management is the worst flaw a company can have.
5. Companies that require continued capital investment
Over the long term, shareholders make spectacular returns by buying businesses that are able to achieve extraordinary returns on capital. This leads to excess capital that the company can use to repurchase shares, pay a dividend to shareholders, or reinvest in further growth.
The upshot
These characteristics don't necessarily make a company a bad investment. Dow Chemical for instance, has been a great long-term investment despite ongoing R&D and capital expenditures. But a solid understanding of why these types of companies may be undesirable can help you identify whether a company that looks good on the surface might actually cost you money later.
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