gsg_stock discussion

Dreadful Stocks to Avoid

Below is an article that could be useful to avoid losses :)

Dreadful Stocks to Avoid
By Richard Gibbons July 21, 2006

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 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 more than 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 Juniper Networks (Nasdaq: JNPR) has been successful is that it has been able to continually develop new networking hardware. Nevertheless, there is a downside to research. Often, innovative companies are required to do research simply to maintain their competitive positions. And if the research dries up, a company suffers.

For instance, consider the plight of Pfizer (NYSE: PFE). Like many of the huge pharmaceutical companies, Pfizer had an impressive history of earnings growth because of new drug discoveries. But now Pfizer's struggling. Not only is it facing lawsuits over Celebrex and Bextra, but its labs are laboring to find new drugs to replace the old. And in 2011, its biggest drug, Lipitor, is coming off patent. As a large pharmaceutical, it still has many dominating competitive advantages, but fears about its pipeline have kept investors away from the stock.
Thus, tech firms, pharmaceuticals, and other companies dependent on research constantly have to be wary of their innovation failing. This is in stark contrast to a company such as American Express (NYSE: AXP), 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 or pharmaceutical stocks, I can understand why Buffett tends to avoid 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 airlines like AMR (NYSE: AMR) and UAL (Nasdaq: UAUA). Both have billions of dollars of debt because they needed to take on that debt to build out their routes and pay the bills during hard times. But when the travel cycle hits a trough, the debt is frequently too large to service, and airlines can be forced into bankruptcy, as UAL was recently.

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 frequently blaming 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 dividends to shareholders, or reinvest in further growth. Companies that constantly need to make additional capital investments 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.

Semiconductor companies, because of the huge expense of building and maintaining chip-fabrication facilities, also suffer from this disadvantage. Chartered Semiconductor Manufacturing (Nasdaq: CHRT) for example, has found profits and free cash flow hard to come by while spending the majority of its revenue over the past few years on capital expenditures.

The upshot

These characteristics don't necessarily make a company a bad investment. Intuitive Surgical (Nasdaq: ISRG), for instance, has been a great investment over the past few years, 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.

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. Pfizer is an Inside Value recommendation. Intuitive Surgical is a Rule Breakers recommendation. The Motley Fool has a disclosure policy.

posted by gsg @ 1:39 PM