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Why Warren Buffett Avoids These 3 Types of Companies

Minimising your losers is an absolutely crucial part of successful investing. All investors make mistakes, but if you can reduce the number of ‘unforced errors’, the ‘winners’ you hit will really count.

Legendary investor Warren Buffett has offered many insights over the years into what he invests in and why, but, equally, he’s had much to say about what he doesn’t invest in.

Here are three tips from Buffett that could help make you a more successful investor.

Tip #1

Buffett has what he calls a ‘circle of competence’ — a cumulative knowledge of a number of industries built up over the years — and he largely sticks to what he understands. His advice to investors starting out is to begin developing a circle of competence by focusing on “simple, understandable, strong businesses.”

As an example, Buffett has invested in Coca-Cola for many decades. This is a simple, understandable and strong business — and it’ll be doing fundamentally the same thing in five, 10 or 20 years’ time as it’s doing now.

Buffett avoids investing outside his circle of competence. There may be times when you see share prices flying in some industry you don’t understand and other investors coining it. Don’t let envy tempt you away from your circle of competence. It can often end in tears, as it did for many investors in the dot.com bust.

Tip #2

Some businesses are simple and easy to understand but not strong. Companies that require large amounts of capital investment, but which have no durable competitive advantage (such as a monopoly position or brand strength) and thus no pricing power, aren’t strong businesses.

Buffett has singled out commercial airlines as a particularly pernicious example: “The airline industry’s demand for capital ever since that first flight [by Orville Wright] has been insatiable. Investors have poured money into a bottomless pit …”

Of course, some investors have made money by buying and selling airline shares at the right times over the decades. But for Buffett, whose ideal holding period for a stock is “forever“, capital intensive businesses with no durable competitive advantage make no sense as an investment.

Tip #3

The third ‘avoid’ tip of Buffett’s I want to highlight can apply to any company in any industry.

Buffett has said: “We’ll never buy a company when the managers talk about EBITDA [earnings before interest, tax, depreciation and amortisation]. There are more frauds talking about EBITDA. That term has never appeared in the annual reports of companies like Wal-Mart, General Electric, or Microsoft. The fraudsters are trying to con you or they’re trying to con themselves.”

Buffett’s partner Charlie Munger has been equally scathing: “I think that, every time you saw the word EBITDA [earnings], you should substitute the word ‘bullshit’ earnings.”

I might not go as far as Buffett and Munger in never buying a company where directors talk about EBITDA. For example, I will forgive a mention of the term if they also speak upfront and transparently about cash flow. However, routinely avoiding companies where management attempts to make EBITDA the primary measure and focus would doubtless save investors many disasters.

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G A Chester has no position in any shares mentioned. The Motley Fool owns shares of General Electric and Microsoft.

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