There's nothing wrong with fixing your focus on trying to find the next Wal-Mart. After all, isn't that what we're here for in the first place?
But before you go diving in after that hot new small-cap stock you found, let's take a moment to remember some of Warren Buffett's priceless investment advice: "Rule number one: Never lose money. Rule number two: Never forget rule number one."
Maybe we should rename Warren "Capt. Obvious."
But as obvious as Buffett's advice may seem, it's an important and often overlooked aspect of investing. So how do we avoid losing money? I've found a few great lessons from some of the past decade's worst investments.
1. Poor business model
In Buffett's 2007 letter to Berkshire Hathaway
Buffett's prime example of a gruesome business? Airlines. And he's not alone in thinking this. Robert Crandall, the former chairman of American Airlines, once said:
I've never invested in any airline. I'm an airline manager. I don't invest in airlines. And I always said to the employees of American, "This is not an appropriate investment. It's a great place to work and it's a great company that does important work. But airlines are not an investment."
Now you might say "Sure, legacy carriers like Delta
However, a glance at Southwest's financial results suggests that as it continues to mature it may have more in common with the legacy carriers than investors might hope. Over the past 10 years, the company has earned $11.5 billion in operating cash flow and spent $11.1 billion on capital expenditures. So over the past decade, a mere $470 million -- or $0.64 per share -- of cash has been left over for shareholders.
To put that in perspective, consider Seagate Technology
Of course, investing large amounts of capital into a business isn't a bad thing in itself. However, investors need to be sure that there's a good chance that capital investments will actually translate into healthy shareholder returns.
2. Sky-high valuation
We can take our pick of overvalued stocks when looking back 10 years, but Dell
Dell had a lot going for it back in 2000 -- it was growing like a weed and wowing investors and analysts with its innovative "just in time" manufacturing model. And, in fact, Dell continued to grow and expand and by January of last year had grown its revenue 140% from 2000.
However, the 84 price-to-earnings multiple that investors awarded the stock at the beginning of 2000 was absolutely ludicrous. As is often the case in an area of great opportunity like PCs, Hewlett-Packard
As Buffett has said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." And it's never a good idea to own even a great company at an absurd price.
3. Loss of focus
What exactly was it that made E*TRADE so successful for so many years? That's simple: It was a leader in the online brokerage market, making it easier for Fools like us to buy and sell stocks, bonds, mutual funds, and options.
However, the need for speed on the growth front, along with the precrash excitement in the housing and credit markets, led E*TRADE to rapidly bulk up its lending activities and investment portfolio, including feasting on food-poisoning-inducing asset-backed securities. As it turns out, E*TRADE wasn't especially good at managing these areas, and when all hell broke loose in 2008, the company found itself on the brink of extinction.
E*TRADE competitors like TD AMERITRADE
Successful companies tend to be successful because they're good at their core business -- online brokerage services in E*TRADE's case. Is it possible for a company to branch out in a related area and be successful? Absolutely, but investors should always be on high alert when a company charges full throttle into uncharted waters.
The best of both worlds
Keeping these lessons in mind when evaluating an investment will help you avoid some of the next decade's worst investments, but they may also help you achieve the goal that we started with -- finding the next Wal-Mart. After all, Wal-Mart is a company with a great business model and a laser-like focus on its core low-priced-retail strategy, and it's been a fantastic investment for those who bought at a fair price.
The investing team at Motley Fool Hidden Gems focuses all of its time sorting through the world of small-cap stocks -- the prime hunting ground for tomorrow's Wal-Marts. By looking for the very best businesses and recommending them when the price is right, the newsletter has uncovered big winners for subscribers.
If you'd like to check out what the Hidden Gems team is looking at today, you can take a free 30-day trial.
This article was originally published Jan. 4, 2010. It has been updated.
Fool contributor Matt Koppenheffer owns shares of Berkshire Hathaway, but does not own shares of any of the other companies mentioned. Berkshire Hathaway and Wal-Mart are Motley Fool Inside Value recommendations. Berkshire Hathaway and Charles Schwab are Stock Advisor selections. The Fool owns shares of Berkshire Hathaway. The Fool's disclosure policy has never once been caught with its pants down. Of course, it doesn't actually wear pants ...