Warren Buffett Doesn't Buy Junk Stocks (but Maybe You Should)

Warren Buffett became the greatest investor of his generation by following a relatively simple philosophy: buying great companies at good prices. A look at Berkshire Hathaway's stock performance since 1990 clearly demonstrates Buffett's success.

BRK.A Chart
BRK.A Chart

Berkshire Hathaway Price Chart (1990-present). Data by YCharts.

That said, it's harder than ever to find great companies at good prices today. The proliferation of information has made it easier to spot companies that have a durable competitive advantage of some sort, which tends to drive up their stock prices. For example, while I like Amazon.com's business, the company trades for more than 70 times forward earnings, far more than I'd be willing to pay. Furthermore, Buffett has a big advantage over ordinary investors today. His past success opens up opportunities not available to the general public, such as access to preferred stock deals and private transactions.

Dumpster diving for stocks!
The difficulty of finding great companies at good prices can be discouraging for everyday investors. As a result, I often like to go dumpster-diving for stocks! While great companies are worth more than good companies, mediocre companies, and downright "bad" companies, every company has a value that's usually not zero (though there are exceptions!). If you can find an adequate margin of safety, you may be able to generate strong returns from owning not-so-strong companies. Don't believe me? Take a look at this stock chart:

BBRY Chart
BBRY Chart

BBRY, BBY, DELL, and HPQ: November 1-present, data by YCharts

The above chart tracks the performance of four companies -- Best Buy , BlackBerry , Dell , and Hewlett-Packard -- vs. the S&P 500 since last November. Whereas the S&P 500 has gained nearly 10%, each of these four companies is up more than 50% in less than six months!

You can rest assured that Warren Buffett would not touch any of these stocks, and not just because he does not like to invest in the tech sector. Best Buy has experienced stagnant sales and falling earnings for the past year or so, due to heavy competition from Amazon. Dell and HP have each seen their PC businesses cannibalized by Apple's iPad and other tablets. According to a recent Dell proxy filing, a Boston Consulting Group study concluded that Dell is likely to see a $10 billion drop in PC revenue over the next four years. HP has also seen disappointing results from most of its other business lines recently, and has experienced significant leadership turnover. BlackBerry was also a victim of Apple's rise, as it went from being the smartphone king to an also-ran in just a few short years. While shares have more than doubled since September, it is nevertheless true that, in two short years, the stock has dropped from $55 to $15.

The big idea
Out of favor "dumpster" stocks can be great investing opportunities, because Wall Street tends to turn against these companies all at once. When problems first surface, analysts are often slow to recognize the severity of the threat. Once it becomes obvious that a company like HP or Best Buy is experiencing a significant decline in profitability, analysts rush to cut their ratings and price targets. The result is typically a steep fall in the stock price, which can lead analysts to cut their price targets yet again.

By the end of this process, the stocks have been beaten down so much that value investors can frequently find very good bargains. At their lows last November, Best Buy, Dell, and HP were all trading for three-to-five times earnings. These prices implied that -- for all the problems these companies already faced -- investors expected the future to be much worse. For the stocks to rally, the companies merely needed to demonstrate that they were starting to stabilize their businesses.

It should go without saying that a "dumpster-diving' strategy wouldn't work for companies that are actually headed for bankruptcy. However, HP, Dell, and Best Buy remained profitable in spite of their difficulties. In my analyses of HP and Best Buy last November (I wasn't actively covering Dell at the time), I found that both companies were trading for well below their long-term valuations.

Recognize the risks
While dumpster diving for stocks can be a profitable enterprise, investors should be ultra-cautious when investing in troubled companies. All of the dumpster stocks I highlighted above caused investors significant pain in the months and years prior to their recent rallies. There are a few ways to make sure you win more often than you lose.

1) Margin of Safety: Always build in a big margin of safety when buying stock of a company with significant competitive challenges. Simply put, that means that you should try to calculate a very conservative estimate of what the company is worth, and only buy the stock if it drops (for example) 20%-30% below that conservative valuation. It's better to miss some opportunities than to overpay for a company with uncertain prospects.

2) Start small: Don't bet your whole fortune on a dumpster stock you've just discovered, even if you think it is substantially undervalued. Start small, and if the price continues to drop, consider that as an opportunity to buy more.

3) Be patient: It can take years for a stock to come in line with its "intrinsic value." While it's nice when dumpster stocks quickly spring back to life -- like the four I highlighted above -- this investing strategy requires taking a long-term view of what a company is worth. (I was very surprised at how quickly HP and Best Buy rebounded from their lows)

4) Stay detached: Keep up to date on the company's fundamentals (particularly earnings performance), and make sure that nothing significant has changed from your initial evaluation of the stock. If the company's problems are much more severe than you anticipated, you need to be ready to cut your losses.

5) Consider options strategies: Options are volatile investment vehicles compared to stocks, and are not suitable for beginning investors. However, if you understand how options work, they can be useful for investing in companies where it's hard to calculate the intrinsic value. For example, look at BlackBerry's earnings for the past three years:

BBRY EPS Diluted Quarterly Chart
BBRY EPS Diluted Quarterly Chart

BlackBerry EPS, past three years: data by YCharts

Through 2010 and early 2011, BlackBerry appeared to have steadily rising earnings. Then, the QNX operating system (which eventually became BB10) was hit with multiple delays, BlackBerry's market share sank, and by mid-2012, the company was losing money. Call options allow you to minimize your downside in the event that things go south. That's a big advantage, since it's impossible to be right 100% of the time.

Foolish conclusion
Dumpster diving for stocks should never be the "bread and butter" of your investing approach. By nature, it is somewhat more speculative than investing in higher-performing businesses, although the focus is still on long-term value. If you can find a great company at a good (or great) price, that should be your first investing target! I think Apple might be such a company today.

Nevertheless, sometimes it's hard to find many great companies at acceptable prices. In that case, investors with a long time horizon can profit from the market's occasional irrationality by investing in beaten-down stocks when Wall Street becomes overly pessimistic. Disagree? Let me know in the comment box below!

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The article Warren Buffett Doesn't Buy Junk Stocks (but Maybe You Should) originally appeared on Fool.com.

Fool contributor Adam Levine-Weinberg owns shares of Apple, Hewlett-Packard Company, and BlackBerry, and is long Jan 2014 $13 Calls on BlackBerry. Adam Levine-Weinberg is short shares of Amazon.com. The Motley Fool recommends Amazon.com, Apple, and Berkshire Hathaway. The Motley Fool owns shares of Amazon.com, Apple, and Berkshire Hathaway. 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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