As investors, we're always searching for undervalued stocks that are going to shower our portfolios with riches. Ideally, we would find stocks that not only outperform but also crush the market and turn a small portfolio into a life-changing sum of money. In search of these big winners, sometimes even the best investors get big eyes and bit off a little more than they can chew.
Below, I have outlined four things I now consider more heavily than ever, after making mistakes of my own and watching some of the world's most famous investors suffer losses in their own portfolios.
Nothing beats a lasting competitive advantage
One of Warren Buffett's secrets is that he invests in companies that will go on forever. He avoids boom-and-bust biotech companies, Internet stocks, and retail fads. Instead, he focuses on life insurance, railroads, and mega brands like Coca-Cola that won't be replaced anytime soon -- companies with a lasting competitive advantage.
These companies may not be flashy investments, but Buffett has a proven ability to pick companies that aren't losers. And sometimes picking companies that don't lose you money is more important than finding companies that make you money.
Competitive advantages can come in a variety of shapes and sizes. It could be a strong brand like Coca-Cola, a more capital-intensive business that turns away potential competitors, or a strategic position that's utterly impenetrable. Finding how your investments fit into the competitive business environment can tell just how strong its competitive advantage is.
Leverage can kill
Investing with leverage doesn't always mean borrowing money yourself to increase your balance sheet. It can also be embedded in the stocks you buy.
Gaming stocks, an industry I follow closely, are usually highly leveraged companies. They borrow massive amounts of money to build resorts and count on constantly rising revenue to keep them afloat. When the recession hit, gaming revenue in Las Vegas' highly leveraged gaming companies like Las Vegas Sands (NYS: LVS) , MGM Resorts, and Caesars Entertainment (NAS: CZR) struggled to keep their heads above water. The resulting drop in stock prices even left Sheldon Adelson, one of the richest men in the world before the recession, digging into his own pockets to save Las Vegas Sands from bankruptcy.
Today, companies and investors are rethinking the value of cash on their balance sheets. Excess cash was once viewed as a sign that management was running out of quality investment options. Now, it's viewed as a sign of strength and conservative management. Recently, even Adelson has become more conservative with leverage, reducing what his company owes and increasing cash reserves to make his company less risky.
Tech giants Intel (NAS: INTC) and Microsoft (NAS: MSFT) have come to appreciate how low leverage can help their businesses and stock prices, building war chests of $14.8 billion and $51.7 billion of cash and investments, respectively. Cash provided downside protection for skittish investors when the market turned, and it can be used to expand at opportune times. Intel bought McAfee for $7.68 billion in cash in 2010, while Microsoft added Skype last year for $8.5 billion in cash -- purchases that wouldn't have been as easy to make with a highly leveraged balance sheet.
Risk doesn't always pay
At The Motley Fool, we love looking for the next Microsoft, Netflix, or Apple to supercharge our readers' portfolios. The term multibagger is a part of our terminology and our market-beating Rule Breakers newsletter is constantly looking for the next 10-bagger stock.
But balancing your portfolio with safer stocks and avoiding being too enamored of growth is key for investors. Looking back at Netflix over the past year, can see the downside of being enamored of growth. The stock traded at crazy multiples because the company seemingly couldn't stop growing. But a misstep here and a price increase there sent the stock into a downward spiral. Without a cash cushion or an indestructible competitive moat, there was little to this high risk growth stock up.
Risk can be great, and I love looking for the next rocket stock as much as the next Fool. But slow and steady wins this investing race, and falling in love with the chase of multibaggers can come back and bite you.
The turnaround is always a risky bet
The U.S. was built on underdogs emerging from the ashes to build some of greatest companies in the world. But betting on the turnaround of previously powerful companies can be a major risk to your portfolio, something some big-name investors are learning the hard way.
Eddie Lampert built a reputation as a shrewd hedge fund manager who built a multibillion-dollar fortune on positions in AutoNation and AutoZone. But he has struggled to find the same success at Sears Holdings (NAS: SHLD) , where he tried to combine floundering Sears and Kmart brands. Not only was it the wrong time to bet on a retail turnaround, but Lampert picked two brands that were so far gone that there was no coming back.
Another famous investor, John Paulson, had one of his worst years in 2011, party because of a turnaround bet on Las Vegas giants MGM Resorts and Caesars Entertainment. His 9.9% stake in Caesars was not only a bet on a Las Vegas turnaround; it was a bet on an extremely highly leveraged company with $20 billion of debt.
Then, there's the formerly powerful Kodak, which touted a strong portfolio of patents before filing bankruptcy. That turnaround barely got off the ground before crashing and burning.
Betting on a turnaround is risky and provides little room for error in your investments.
Foolish bottom line
If you're able to find companies with a strong competitive moat, low leverage, and a low risk business, you're well on your way to building a strong portfolio. I've build a portfolio based around Intel, Microsoft, Apple, and Berkshire Hathaway, companies that I think fit all of these criteria well.
For more top picks from our analysts check out our free report called "Secure Your Future With 11 Rock-Solid Dividend Stocks". The report is free for a limited time if you click here.
At the time thisarticle was published Fool contributor Travis Hoium manages an account that owns shares of Apple, Berkshire Hathaway, Intel, and Microsoft. You can follow Travis on Twitter at @FlushDrawFool, check out his personal stock holdings or follow his CAPS picks at TMFFlushDraw.The Motley Fool owns shares of Intel, Microsoft, Berkshire Hathaway, Coca-Cola, and Apple. Motley Fool newsletter services have recommended buying shares of Coca-Cola, Berkshire Hathaway, Apple, Microsoft, Intel, and Netflix, as well as creating bull call spread positions in Apple and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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