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 Buffett "Captain 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 shareholders, he described three types of businesses: the great, the good, and the gruesome. He described the "gruesome" type as a business that "grows rapidly, requires significant capital to engender the growth, and then earns little or no money."
Buffett's prime example of a gruesome business? Airlines. And he's not alone in thinking this. Robert Crandall, 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 UAL
Unfortunately, JetBlue is also a pretty poor spokescompany for investing in airlines.The stock dropped drastically since its initial public offering, and its cash flow statement is just about as ugly as some of the legacy carriers'.
Over the past five years, the company has taken in roughly $1.3 billion in operating cash flow. Meanwhile, it's spent $4.7 billion on capital expenditures. Not only does this leave nothing behind for shareholders, but it's also forced the company to raise $2.4 billion in net new debt.
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 Cisco
Cisco had a lot going for it back in 2000 -- it was growing like a weed and providing the hardware that created the backbone for the red-hot Internet sector. And, in fact, Cisco continued to grow and expand and by January of this year had grown its net income 127% from its fiscal 2000 year's end.
And I don't think the good times for Cisco will end quite yet. For companies like Amazon.com
However, the price-to-earnings ratio of more than 200 that Cisco had in early 2000 was absolutely ludicrous. Growth and industry dominance couldn't fight this extreme overvaluation and Cisco's stock is still down nearly 70% from its peak levels in early 2000.
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
It may seem hard to think back to a time when the name American International Group
AIG had built itself into one of the largest insurers in the world, and indeed one of the largest public companies in the world. Not surprisingly, it achieved this stature by being a great insurer, taking on a variety of lines from commercial property and casualty to individual life.
Perhaps in an effort to try and capture some of the magic that seemed to let firms like Goldman Sachs
Between 2005 and 2007, AIGFP boosted its credit default swap portfolio by 45% -- to $562 billion. Though AIGFP accounted for a very small portion of AIG's overall earnings, the overreaching into the area of ungoverned financial products was enough to bring the company to its knees.
While the recession was no cakewalk for other insurers like MetLife
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. 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 selections. Google is a Rule Breakers pick. Amazon.com and Berkshire Hathaway are Stock Advisor recommendations. 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 ...