Dreadful Stocks to Avoid

Dreadful Stocks to Avoid

By Richard Gibbons

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 for himself, 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 periodically 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 is no "three strikes and you're out" policy. One strike, and it's game over -- your money's gone. Consider Boeing's conundrum in the superjumbo jet market. Developing a new jet costs billions of dollars, which can be recouped only if the jet proves to be a huge success. Boeing's competition, Airbus, already has nearly 150 orders for its A380 superjumbo. But Boeing's research shows that airlines are moving away from a hub-and-spoke model. Thus, Boeing is betting the farm against the superjumbo, opting instead to develop the 787, a smaller, long-range jet that it expects to better address the market's needs. But if Boeing's analysis is incorrect and the market moves toward the superjumbos, it will lose customers. Either way, it's a tough decision with potentially terrible consequences for Boeing.

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 Johnson & Johnson (NYSE: JNJ) has been so successful is that it has been able to continually develop new drugs and medical technology. 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. For instance, consider the plight of Sun Microsystems (Nasdaq: SUNW). In the late '90s, Sun was well known both as the company that won the proprietary UNIX server war and as the creator of the popular multi-platform Java programming language. But Sun's research programs failed to come up with any spectacular successes to keep the company ahead of its competitors. So, when Linux started taking over in servers, and Microsoft corrupted Java's portability with its own Windows-specific functionality and then copied Java's ideas for its own C++ programming language, Sun crumbled. This is a stark contrast to a company like Hershey (NYSE: HSY), 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 technology 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.

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 preventing 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, or frequently blaming external circumstances for operational shortcomings. WorldCom and Enron may have gone up 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. In other words, everyone except shareholders. Obviously, many energy companies fall into this category. After all, finding and extracting oil, maintaining infrastructure, and complying with environmental regulations all require cash. Talisman Energy (NYSE: TLM) and Occidental Petroleum (NYSE: OXY), for instance, both had capital expenditures of about $2 billion last year, growing at a rate of 25% annually over the past five years. While this may not affect these companies right now -- they're flush with cash from high oil prices -- if prices fall, the story could change quickly.
Semiconductor companies, because of the huge expense of building and maintaining chip-fabrication facilities, also suffer from this disadvantage. Micron Technologies (NYSE: MU), for example, has been spending more than $1 billion a year on capital expenditures -- more than one-fifth of its revenue.

The upshot
Having these characteristics doesn't necessarily make a company a bad investment. Oracle (Nasdaq: ORCL), for instance, has been a great long-term investment, despite heavy R&D 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.