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 $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? My answer, and the answer of my colleagues at Motley Fool Inside Value, is "Heck, no!" If I make only $40 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.
Shareholders of drugmaker Dendreon (Nasdaq: DNDN ) over the past three years should know this all too well. One day the FDA loves you and all is well; the next, you've been dealt a regulatory setback, and with that setback goes your stock price. Today, Dendreon is just fine, but the point is made. In this market, 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 Qualcomm (Nasdaq: QCOM ) has been such an omnipresent force is because the company is constantly developing innovative products.
Nevertheless, there is an obvious downside to research and development. Often, innovative companies -- even stalwarts like PepsiCo (NYSE: PEP ) -- 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 SanDisk. Like many of the huge chip companies, SanDisk has had impressive periods of earnings growth because of new breakthrough products and promising future developments. But for several years now, SanDisk has been languishing. If you live by research -- you can die by it too.
This is in stark contrast to a company like Wal-Mart (NYSE: WMT ) , which could do nothing but keep running its mega-efficient retail operation for the next decade and still have a 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 tries to avoid 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 Delta and US Airways. Both have billions of dollars of debt because they needed to take on that debt to build out their network enough to compete. While their debt probably won't be the direct thing that does them in, they now have to pay back that money while trying to evolve and compete with other ferocious competitors in the airline industry.
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 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 Dow Chemical (NYSE: DOW ) , a company that must continually reinvest in the expensive equipment required to manufacture chemicals and its performance over the long term. It's unimpressive. Even if things were perfect in the global market for specialty chemicals (which they're not), every year shareholders would still have to bear the heavy costs of manufacturing these products. It's not an ideal situation.
Compare that to companies like Amazon.com and eBay (Nasdaq: EBAY ) , whose virtual electronic platforms require minimal regular upkeep. From a reinvestment standpoint, these situations are far superior.
All of these characteristics don't necessarily make a company a bad investment. Google (Nasdaq: GOOG ) , 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 and owns shares of Google and eBay. Wal-Mart Stores is a Motley Fool Inside Value recommendation. Google is a Rule Breakers selection. Amazon.com and eBay are Stock Advisor picks. PepsiCo is an Income Investor choice. Motley Fool Options has recommended a bull call spread on eBay. The Motley Fool has a disclosure policy.