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. 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 Texas Instruments (NYSE: TXN ) has been so successful over the very long term is that it has devoted so much to top 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, which is what short-term holders of the company may be experiencing now.
For instance, consider the plight of AMD (NYSE: AMD ) . Like many of its semiconductor brethren (including Texas Instruments and Intel (Nasdaq: INTC ) ), AMD lives and dies by delivering cutting-edge computer chips. But over a decent period of time now, 10-plus years, AMD has been unimpressive -- and has lost to the overall market. Thanks to various product-related problems and the fierce nature of the industry itself, shareholders are not being properly rewarded.
This is in stark contrast to a company like Coca-Cola (NYSE: KO ) , which could literally develop nothing for a decade, and still have a very healthy business to reward shareholders. 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 numerous airlines -- Delta in particular. The company has billions of dollars in debt, at levels that exceed its market cap. More importantly, without this debt it cannot build out its ability to serve customers.
By the way, Delta's debt issues are rarely limited to the company itself. Consider the second-order effects of Delta's hypothetical collapse on companies like Boeing (NYSE: BA ) and even debt financiers like JP Morgan (NYSE: JPM ) . All around, it's not a good situation, but especially as a direct investor.
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. If you're sitting on one of the big banks these days (whether it's Citigroup or Wells Fargo (NYSE: WFC ) ) you better be prepared for continued capital investment to support the companies' respective balance sheets.
Without properly understanding the quality of these banks' underlying assets, it's impossible to know how safe your position really is. And more to the point, future capital infusions (regardless of whether they come from public or private sources) may help the banks as an institution, but they certainly don't help you as a shareholder.
These characteristics don't necessarily make a company a bad investment. Johnson & Johnson, 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 does not have a position in any of the companies mentioned in this article. Intel and Coca-Cola are Motley Fool Inside Value picks. Johnson & Johnson and Coca-Cola are Income Investor picks. The Fool has a covered strangle on Intel. Motley Fool Options has recommended buying calls on Intel and on Johnson & Johnson. The Motley Fool has a disclosure policy.