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. But Buffett's done pretty well, so it seems unwise to simply dismiss his advice as the semicoherent ramblings of a man who's read way too many 10-Ks.

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 $60 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 $60 billion? My answer, and the answer of my colleagues at Motley Fool Inside Value, is "Heck, no!" If I make only $60 billion, I'll be perfectly satisfied.

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. Although Crocs (Nasdaq: CROX  ) has attempted to diversify its revenue stream, the success of the company is all but tied to a pretty lame pair of sandals -- and we've witnessed what happens when consumers no longer fancy a fad. There's no "three strikes and you're out" policy in this market. 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. In fact, one reason Amgen (Nasdaq: AMGN  ) has been so successful is that it has devoted so much to top-notch research and development. 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.

For instance, consider the plight of Schering-Plough. Like many of the huge pharma companies, Schering-Plough had a long and impressive history of earnings growth because of new breakthrough products and a promising pipeline. But in the past five years, Schering has been unimpressive. The company has seen various problems within its pipeline, costs are adding up, and recently we've all heard about the disastrous saga starring former blockbuster Vytorin.

This is in stark contrast to a company like Altria (NYSE: MO  ) , which could develop nothing for a decade and sadly still have a very healthy business. 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. You can see this with shipping companies such as DryShips (Nasdaq: DRYS  ) and Frontline (NYSE: FRO  ) . Both have billions of dollars in debt at levels which exceed their respective market caps. More importantly, they rely on this debt to build out their logistical capacities -- it's a necessity. Now that they're in an incredibly volatile shipping market, the two must pay back that money while trying to compete in a constantly changing macro environment.

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. Some clues to look for here include excessively optimistic press releases, overly generous compensation or options grants, and a frequent tendency to blame external circumstances for operational shortcomings. WorldCom and Enron shares may have risen for years, but at the end of the day, shareholders received almost nothing. 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. Companies that constantly need to make additional capital investment to keep the business going are the antithesis of this ideal -- the main beneficiaries will be employees, management, suppliers, and government. Look at Motorola (NYSE: MOT  ) and its performance over the past 15 years to substantiate this point. In other words, everyone profits except shareholders.

The upshot
These characteristics don't necessarily make a company a bad investment. Qualcomm (NYSE: QCOM  ) , 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.

We use similar techniques at Inside Value. With every stock, we cautiously evaluate each of these factors -- focusing on competitive advantages, potential threats, the balance sheet, and anything we can glean from SEC filings -- to determine whether the business is likely to provide a solid return for shareholders in the future. In our initial recommendation of any company, we discuss the risks the company faces and provide updates when new risks appear on the horizon. By focusing on great businesses and understanding the potential risks of any company, we endeavor to achieve Buffett's first rule -- "Never lose money." To see the companies we've identified, take a 30-day guest pass to Inside Value. There's no obligation to subscribe.

This article was originally published Oct. 7, 2005. It has been updated.

Fool contributor Richard Gibbons has forgotten what rule No. 2 is. He has no position in any of the companies mentioned in this article. The Motley Fool has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (44)

Comments from our Foolish Readers

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  • Report this Comment On October 05, 2009, at 4:41 PM, sownman wrote:

    Wow, what a shock Motley Folly doesn't like DRYS.

    How big is your short position anyway ?

    Surprised you didn't work LVS into this as a terrible company as well. Did you cover that one on Cramers advice ?

    Idiots

  • Report this Comment On October 06, 2009, at 4:49 PM, Roostertail56 wrote:

    Wow! Sownman, some of that keyboard bravado eh?

    Nothing like calling people names when you disagree with them. Shows some real intelligence....

    Don't hide behind the keyboard, why don't you go and find the author and call him some names to his face. See how far that gets you on the respect meter...

    LOL

  • Report this Comment On October 07, 2009, at 5:06 PM, plange01 wrote:

    stocks to avoid? dont forget hertz the near bankrupt hedge fund controlled car rental company.this is the worse of all!!

  • Report this Comment On October 08, 2009, at 12:46 PM, ShortPlaya wrote:

    Warren Buffet is a genius. Now that I have said that everyone will respect my opinion. Or did he just get in the game with a novel approach some 100 years ago and get the jump on everyone? I noticed the related tickers on all the stocks you love to hate are smokin today. Have you ever walked in a crocs store? They are flying off the shelves. You seem to have a hatred for someone in upper management there by the way you ignore the obvious. Crocs has a product nobody else has. End of story. Wait and see the quarterly earnings then spout off some more.

  • Report this Comment On October 08, 2009, at 1:56 PM, mcbowler78 wrote:

    Sweet! more Crocs hate. Looks like its time to buy again. I have a stop order buy at 7.40 in case it breaks out. Perfect chart if you are into patterns.

  • Report this Comment On October 09, 2009, at 1:10 PM, actuary99 wrote:

    ShortPlaya -

    Are you familiar with the term "anecdotal evidence"? Most Fools are smart enough to recognize and ignore it. You're wasting everyone's time when you use anecdotal evidence for your argument on this site.

  • Report this Comment On October 09, 2009, at 7:04 PM, Kevin062 wrote:

    What is going on here? Whether you like Warren Buffett or not he has been extremely successful at what he does by anyone's standards and there is no need for name calling. If you do not agree with him then follow a different strategy and make your own name. Personally do not care for CROCS but obviously a significant portion of the population does so why not invest in it and take it as it comes or goes. Again no need for name calling.

    I do think that lomaxlovescrocs does need to take his (or her) medicine and I do find it coincidental that the username just happens to contain the lovescrocs. What did you do, create a new identity just to post in this thread? why is two thirds of this thread dominated (23 /30 posts) occupied by you, do you have anything real to do?

    Let's keep it to discussions on investing and trying to improve our future, and save the ranting for other sites.

  • Report this Comment On October 10, 2009, at 11:52 PM, dcohn wrote:

    I agree with Kevin062 and I am a little confused how allowing one user to post 75% of the content of a thread is within fools guildelines.

    Surely having officers of a company come here and spout this way must be wrong somehow.

    Fools Rules says:

    Post or transmit any content that is disruptive, uncivil, abusive, vulgar, profane, obscene, hateful, fraudulent, threatening, harassing, defamatory, or which discloses private or personal matters concerning any person;

    and

    Post or transmit any advertising, promotional materials, or other forms of solicitation,

    Seems like those rules were broken by lomaxlovescrocs .

    Hey moderator how about deleting those posts

  • Report this Comment On October 11, 2009, at 5:19 PM, stanton17 wrote:

    For the "alternative energy" proponents, your cause is noble and just. We do need an effective, sustainable, alternative energy strategy (strategies) for the future. However, don't hold your breath for that to occur any time soon. Read the following article and you'll see what you're up against: "Waxman-Markey Flunks Math," at http://blogs.forbes.com/digitalrules/2009/06/waxman-markey-f...

    As for Warren Buffet, he is arguably one of the most successful investors of our time as was Sir John Templeton. Warren Buffet doesn't seek the limelight; it finds him. If it wasn't for the media focus, he'd simply be one of those fabled quiet, unassuming billionaires who is an extremely generous philanthropist for many admirable causes.

    And for everyone who vehemently dislikes Warren Buffet, I'd venture to guess that there's many more who admire him and strive to emulate his investing prowess/success/genius (and if you can't beat 'em, join him: BRK.B).

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