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 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 IBM (NYSE:IBM) has been such an omnipresent force is because the company is constantly creating innovative products or is on the hunt looking for them. Nevertheless, there is an obvious downside to research. Often, innovative companies -- even stalwarts like IBM -- 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 Micron Technology (NYSE:MU). Like many of the huge semiconductors, Micron had impressive periods of earnings growth because of new breakthrough products and promising future developments. But for several years now, Micron has been on a downward spiral. The company has seen problems in its ever-present fight for industry superiority, and earnings have suffered the worse for it. Micron still produces a competitive product, but the race to keep ahead is costing shareholders serious money.

This is in stark contrast to a company like US Bancorp (NYSE:USB), which could develop nothing for a 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 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 while trying 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 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 frequent blaming of 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 AstraZeneca (NYSE:AZN) and its performance over the last few 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. 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.

I encourage you to use similar techniques, as we do 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. By focusing on great businesses and understanding the potential risks of any company, we endeavor to achieve Buffett's first rule -- "Never lose money." If you'd like 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. US Bancorp is a Motley Fool Income Investor pick. The Motley Fool has a disclosure policy.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.