Motley Fool by munificent Blog entry

Blog: Yoga Path
by munificent

Motley Fool

Dreadful Stocks to Aviod-at least for now!Whoops this should be on Spirit of Money! Sorry Yogini's- Motley fool is Fun for all

Date: 10/14/2005 12:56:40 PM ( 19 y ) ... viewed 1693 times

INVESTING

Fool News & Commentary
Dreadful Stocks to Avoid
By Richard Gibbons
October 7, 2005

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 such a strategy, and he's made even more for his partners and shareholders over the years. Do you really need to assume more 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 only make $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 understanding 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 (NYSE: BA) conundrum in the superjumbo jet market. On one hand, developing a new jet costs billions of dollars, which can be recouped only if the jet proves to be a huge success. On the other hand, its competition, Airbus, already has nearly 150 orders for its A380 superjumbo. If the market moves toward the superjumbos and Boeing doesn't have a good solution, it will lose customers. Either way, it's a tough decision with potentially dreadful 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 that 3M (NYSE: MMM) is a Motley Fool Inside Value recommendation is its focus on innovation and the development of new markets. 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 Apple (Nasdaq: AAPL) between the first and second comings of Steve Jobs. The company's research programs failed to come up with any spectacular successes, and Apple lost market share for a decade. The innovative iPod has turned the company around, but the business is still highly dependent on research. This is a stark contrast to a company like PepsiCo (NYSE: PEP), which could develop nothing for a decade and still have a healthy business. While I don't think this is sufficient reason to sell Apple, I can understand why this is one of the reasons Buffett avoids technology 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 they 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 the constant use of external circumstances to excuse 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 from 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 the shareholders.

Obviously, many energy companies fall into this category. After all, finding and extracting oil, maintaining infrastructure, and complying with environmental regulations takes cash. Devon Energy (NYSE: DVN) and Andarko Petroleum (NYSE: APC), for instance, both had capital expenditures of more than $3 billion last year, growing annually at 18% and 29%, respectively, over the past five years. Semiconductor companies, because of the huge expense of building and maintaining chip fabrication facilities, also suffer from this disadvantage. Advanced Micro Devices' (NYSE: AMD) capital expenditures have grown almost 25% annually for the past five years and are now approaching $1.5 billion annually.