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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.

Three years ago, Force Protection (Nasdaq: FRPT  ) was a Pentagon darling building armored personnel carriers for the troops. But contracts disappeared (or went to rivals) and the company got absolutely hammered. Trucks were all it had going for itself. I’m not certain much has changed, either.

The defense industry can be incredibly lucrative, and a diversified player like Northrop-Grumman (NYSE: NOC  ) might do well to pick up Force Protection, which it can do precisely because it doesn’t make a habit of putting all its chips on one, relatively unproven product. Even though Force Protection’s trucks might be perfectly fine, one-trick ponies can quickly see their luck turn around, so avoid them.

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 Procter & Gamble (NYSE: PG  ) has been so successful (and probably always will be) is that it has devoted so much to top-notch research and development.

Nevertheless, there is a downside to research. First, it’s expensive. But innovative companies are often required to do research simply to maintain their competitive position. If the research dries up, the company suffers.

For instance, consider the plight of Sony (NYSE: SNE  ) . Like many huge technology conglomerates, Sony had a long and impressive history of earnings growth because of new breakthrough products. But in the past decade, Sony has been more than unimpressive thanks to a decline in its ability to deliver a differentiated product.

Rivals like Apple and Nokia have crushed the company by seizing the highly lucrative smartphone and personal entertainment device markets. Meanwhile, others have invaded the company’s traditional wheelhouses. Today, it’s hard to say what role Sony has in the 21st-century economy. "Commodity player" seems like the most apt description of the business.

This is in stark contrast to a company like Altria, 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 shipping companies such as DryShips and Frontline. 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 macroenvironment.

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 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. Starwood Hotels (NYSE: HOT  ) is a good example of this point.

Simply said, the hospitality business is not well designed to reward shareholders. Hotels have massive capital requirements, require constant upkeep, and don’t exactly generate tremendous economies of scale. Starwood’s past performance reflects this reality. Going forward, the company will face the same issues, regardless of how good the economy is. Buffett doesn’t like to fight a headwind, which is precisely what this is. Try looking elsewhere.

The upshot
These characteristics don't necessarily make a company a bad investment. ExxonMobil (NYSE: XOM  ) , for instance, has been a great long-term investment despite extensive, ongoing R&D and capital expenditures. Over the next 10 years, Exxon isn’t going to have much of a problem because of this, either. 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." 

This weekend, we're headed to see what else we can learn from Buffett at the annual Berkshire Hathaway conference. If you'd like to hear what we learn first-hand, sign up here for dispatches from the conference itself.

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. Nokia is a Motley Fool Inside Value recommendation. Apple is a Stock Advisor recommendation. P&G is an Income Investor recommendation. The Fool owns shares of P&G. The Motley Fool has a disclosure policy.

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