3 Signs of a Terrible Investment

There's nothing wrong with fixing your focus on trying to find the next Wal-Mart (NYSE: WMT  ) . After all, isn't that what we're here for in the first place?

But before you go diving in after that hot new small cap you found, let's take a moment to remember some of Warren Buffett's priceless investment advice: "Rule number one: Never lose money. Rule number two: Never forget rule number one."

Maybe we should rename Warren "Captain Obvious."

But as obvious as Buffett's advice may seem, it's an important and often overlooked aspect of investing. So how do we avoid losing money? I've found a few great lessons from some of the past decade's worst investments.

1. Poor business model
In Buffett's 2007 letter to Berkshire Hathaway (NYSE: BRK-A  ) shareholders, he described three types of businesses: the great, the good, and the gruesome. He described the "gruesome" type as a business that "grows rapidly, requires significant capital to engender the growth, and then earns little or no money."

Buffett's prime example of a gruesome business? Airlines. And he's not alone in thinking this. Robert Crandall, the former chairman of American Airlines, once said:

I've never invested in any airline. I'm an airline manager. I don't invest in airlines. And I always said to the employees of American, 'This is not an appropriate investment. It's a great place to work and it's a great company that does important work. But airlines are not an investment.'

So then it shouldn't be much of a surprise that AMR (NYSE: AMR  ) , American Airlines' parent, would come up as a stock that has massively underperformed the market. Though American is the only legacy airline not to have declared bankruptcy, the business has performed only marginally over the years, and its voracious appetite for capital has gobbled up all of the company's cash and then some.

Investing large amounts of capital into a business isn't a bad thing in itself. However, investors need to be sure that there's a good chance that capital investments will actually translate into healthy shareholder returns.

2. Sky-high valuation
We can take our pick of overvalued stocks when looking back 10 years, but Yahoo! (Nasdaq: YHOO  ) seems to stick out as a prime example.

Yahoo! had a lot going for it back in 1999 -- it was a pioneer and leader in the Internet search arena, it was growing like a weed, and by the end of 1999 was actually profitable. And, in fact, Yahoo! continued to get even more profitable and managed to expand its revenue 12-fold by the end of 2008.

However, the 259 price-to-revenue multiple that investors awarded the stock at the end of 1999 was absolutely ludicrous. Even if Google (Nasdaq: GOOG  ) had never come along and pushed Yahoo! aside as the industry leader, it would have been nearly impossible for the company to live up to the expectations that Yahoo!'s 1999 valuation implied.

As Buffett has said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." And it's never a good idea to own even a great company at an absurd price.

3. Loss of focus
What exactly was it that made E*TRADE (Nasdaq: ETFC  ) so successful for so many years? That's simple: It was a leader in the online brokerage market, making it easier for Fools like us to buy and sell stocks, bonds, mutual funds, and options.

However, the need for speed on the growth front, along with the pre-crash excitement in the housing and credit markets, led E*TRADE to rapidly bulk up its lending activities and investment portfolio, including feasting on food-poisoning-inducing asset-backed securities. As it turns out, E*TRADE wasn't especially good at managing these areas, and when all hell broke loose in 2008, the company found itself on the brink of extinction.

E*TRADE competitors like optionsXpress and Charles Schwab (Nasdaq: SCHW  ) have either stuck to their knitting or never let their noncore operations get out of control. As a result, their stocks have held up much better through the market turmoil.

Successful companies tend to be successful because they're good at their core business -- online brokerage services in E*TRADE's case. Is it possible for a company to branch out in a related area and be successful? Absolutely, but investors should always be on high alert when a company charges full throttle into uncharted waters.

The best of both worlds
Keeping these lessons in mind when evaluating an investment will help you avoid some of the next decade's worst investments, but they may also help you achieve the goal that we started with -- finding the next Wal-Mart. After all, Wal-Mart is a company with a great business model and a laser-like focus on its core low-priced-retail strategy, and it's been a fantastic investment for those who bought at a fair price.

The investing team at Motley Fool Hidden Gems focuses all of its time sorting through the world of small-cap stocks -- the prime hunting ground for tomorrow's Wal-Marts. By looking for the very best businesses and recommending them when the price is right, the newsletter has uncovered big winners for subscribers.

If you'd like to check out what the Hidden Gems team is looking at today, you can take a free 30-day trial.

Fool contributor Matt Koppenheffer owns shares of optionsXpress and Berkshire Hathaway, but does not own shares of any of the other companies mentioned. Google is a Motley Fool Rule Breakers pick. Berkshire Hathaway, optionsXpress Holdings, and Charles Schwab are Motley Fool Stock Advisor recommendations. Berkshire Hathaway and Wal-Mart are Motley Fool Inside Value picks. The Fool owns shares of Berkshire Hathaway. The Fool's disclosure policy has never once been caught with its pants down. Of course, it doesn't actually wear pants ...

Read/Post Comments (11) | Recommend This Article (104)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 04, 2010, at 10:04 AM, madmilker wrote:

    1. Taking tat squiggly line out and placing it with a single large star.

    2. Buying a "toot" toot" train.

    3. Not supporting American export.

  • Report this Comment On January 04, 2010, at 10:07 AM, xjp83x wrote:

    great article, i agree 100%

  • Report this Comment On January 04, 2010, at 6:06 PM, teddipoo8699 wrote:

    How is it that Warren , et al, does not tout the Buffet "B" shares? .....

    Motley Fool is late to the "recommendation"" party on Yum.......this stock was recommended a few years back in the Cabot Letter...

  • Report this Comment On January 04, 2010, at 7:38 PM, PeterNSmith wrote:

    Warren Buffett is obviously a hero here. Timing is everything when buying and selling. Never seek the lowest buy price or the highest sell price - just seek profit and move on. BTW Fool does not rank well in investment letters.

  • Report this Comment On January 05, 2010, at 11:45 AM, cubmonkeysheep wrote:

    I agree with everything.

    However, could you not stop at " The Best of Both Worlds"?

    You turned a wounderful, well written article into a sales pitch.


  • Report this Comment On January 05, 2010, at 1:03 PM, teddipoo8699 wrote:

    Now , please be true......who of us could afford to buy BRK A shares.....if I were guaranteed $100 a day in the market, I couldd cash in a CD and , buy one share....................however, let me bore you with my experience, true story.......

    Way back when BRK brought out their B shares, I jumped on that like a cat on a hot tin roof......that was a lot of years that very same time Warren ""I would not buy it"" ........BUT I DID BUY IT RIGHT AWAY, I COULD NOT WAIT.........

    I held on , and on , and on, IT WAS LIKE WATCHING PAINT DRY. I think, but right now am not sure, I think I paid $1000 per share. It was so long ago, I would rather forget it. Of course I sold it and until now never looked back.......and honestly I feel like I was the only person on earth who lost money on Buffet.

    When Buffet said he never bet (bought) on Tech stocks because he did not understand them, I would bet you and old hat that he secretly wishes that he had. at least gotten his toes wet. This begs the question, has he learned anything from Bill Gates as yet?

  • Report this Comment On January 05, 2010, at 2:50 PM, mitp wrote:

    E*Trade Financial Corporation (NASDAQ: ETFC) is a great company with a great client base. And it was run into the ground from giving risky loans and acting as the end-user banker. Then it got bailed out in a deal with Citadel which gave the firm an extra layer of trade executions and gave Citadel control over the company’s operations. The dominance of Citadel is not as much as it was in even just a few months ago, but the company is soon to be without its replacement CEO. Things have got better at E*TRADE on operations, and the company’s solid advertising campaign allowed the firm to keep growing at a time in 2008 when suddenly the company appeared to be at-risk. The at-risk issue is one that might not go away for some time because of its loan exposure that it is stuck with and because write downs kept coming. Now, it seems that the wagons may be circling around E*TRADE despite the notion that many dismiss TD AMERITRADE (AMTD) as a suitor. E*TRADE still has a difficult ride if it has to just whether the storm and it may not have the resources needed to ride it out. That will come up for more debate if write downs and charges keep continuing. But for a larger buyer, particularly the non-bank companies that claim to be bank holding companies, then its 2.7 million brokerage accounts and total accounts of more than 4.5 million will be much more valuable to a suitor than to see what is left of the company if the finances turn back south.

  • Report this Comment On January 08, 2010, at 7:04 PM, wolfman225 wrote:

    Ummm....I thought they monitored these posting to eliminate spammy advertising? Please take bccloth to Craigslist. This isn't the forum.

  • Report this Comment On January 08, 2010, at 7:05 PM, wolfman225 wrote:

    check that. they did.

  • Report this Comment On January 08, 2010, at 9:58 PM, ih8aloss wrote:

    In the article Buffett has said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." And it's never a good idea to own even a great company at an absurd price. From the top looking down that makes sense but it doesn't if your at the bottom looking up. New startups like HGUE could very well fit that bottom up bill, a great company at an absurd price.

  • Report this Comment On January 08, 2010, at 10:34 PM, tristaral wrote:

    Wow, what a firm grasp of the obvious!

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