DFN: Do the opposite of making a terrible investment Summary, to make success ‘investments’ focus on companies that have characteristics, the opposite of a terrible investment, ie, they have a good business model; a low valuation; and they’re focused on business.
3 Signs of a Terrible Investment
By Matt Koppenheffer
April 6, 2010
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 US Airways (NYSE: LCC) have an ugly history, but what about younger players like JetBlue (Nasdaq: JBLU)?"
Unfortunately, JetBlue is also a pretty poor spokesman 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 has spent $4.7 billion on capital expenditures. Not only does this leave nothing behind for shareholders, but it has also forced the company to raise $2.4 billion in net new debt.
Of course, investing large amounts of capital in 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 Microsoft (Nasdaq: MSFT) could be a prime example.
Microsoft had a lot going for it back in 2000. The Internet boom was in full swing, making customers absolutely gaga about computer gear and software. And while stodgier companies like IBM (NYSE: IBM) and Apple (Nasdaq: AAPL) (remember, this is the pre-iPod era) were just creeping along, Microsoft was growing like a weed and collecting ridiculously high margins.
And to be sure, the road has continued to be pretty sunny for Microsoft since then. The company’s 2009 earnings per share were more than double what it earned in 2000. And though margins aren’t quite as strong today, the 28% net income margin for 2009 still shows a very profitable company.
However, the price-to-earnings ratio of 78 that Microsoft had at the end of 1999 was simply way too high. Growth and industry dominance couldn’t fight this extreme overvaluation, and Microsoft’s stock is still worth only half as much as it was in late 1999.
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 didn’t make you want to start hitting things with a baseball bat, but the company wasn’t always a symbol of corporate idiocy.
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 to capture some of the magic that seemed to let firms like Goldman Sachs and Bear Stearns (before it was swallowed by JPMorgan Chase (NYSE: JPM)) print money, AIG allowed its financial-products division to take on a huge amount of risk.
From 2005 to 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 and Allstate (NYSE: ALL), both kept more of a lid on their swap exposure, and neither decided to put a gunslinging capital-markets division out there to try to expand outside their core competencies.
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 has 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 team has uncovered big winners for subscribers.
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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, Microsoft, and Wal-Mart Stores are Motley Fool Inside Value recommendations. Apple and Berkshire Hathaway are Stock Advisor choices. Motley Fool Options has recommended a diagonal call position on Microsoft. 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.