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 semi-coherent 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 tens of billions of dollars 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 $10 billion? My answer, and the answer of my colleagues at Motley Fool Inside Value, is "Heck, no!" If I make only $10 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. 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. In fact, one reason Nokia (NYSE: NOK ) has been such an omnipresent force is because the company is constantly creating innovative products, or on the hunt for them. Nevertheless, there is an obvious downside to research. Often, innovative companies -- even stalwarts like GE -- must do research simply to maintain their competitive position. And if the research dries up, the company suffers financially.
For instance, consider the plight of Yahoo! (Nasdaq: YHOO ) . Like many of the dot-coms of its generation, Yahoo! has had oscillating periods of impressive earnings growth, coupled with disappointing stretches of sluggish performance. Though it seems that Yahoo! is turning the corner a bit, investors should probably ask themselves: How long will this last?
The company still can't fight off Google (Nasdaq: GOOG ) on its search properties, and other competitors surely will try to steal traffic from the company's other niche services. Yahoo! still produces a competitive product that many enjoy, of course, but the arms race to keep ahead is not cheap. Let's not forget that Yahoo! management made the decision for shareholders to run this race alone, after rejecting Microsoft's (Nasdaq: MSFT ) numerous offers.
This all stands in stark contrast to a company like McDonald's (NYSE: MCD ) , which could develop nothing for a decade and 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 AT&T (NYSE: T ) and Verizon (NYSE: VZ ) . Both have tens of billions of dollars of debt, because they needed to take on that debt to build out their network capacities enough to compete. While the debt is reasonably manageable for companies of this magnitude, they now have to pay back that money, even as they to evolve and compete with competitors that are invading their traditional niches.
4. Companies with questionable management
Management has incredible power. If executives want to enrich themselves at shareholders' expense, 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 frequently blaming 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. Take a look at Centerpoint Energy, a company that must continually reinvest in its electrical grid; its performance over the last few years substantiates this point. In other words, everyone profits except shareholders.
These characteristics don't necessarily make a company a bad investment. Apple, 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 on Oct. 7, 2005. It has been updated.
Fool contributor Richard Gibbons has forgotten what rule No. 2 is. He owns shares of Google and Microsoft. Nokia and Microsoft are Inside Value recommendations. Apple is a Stock Advisor recommendation. Google is a Rule Breakers recommendation. Motley Fool Options has recommended a diagonal call on Microsoft. The Motley Fool has a disclosure policy.