Warren Buffett won't buy these 3 types of stocks

Warren Buffett: Don't Make This Mistake...

Many people are surprised the first time they look at the stock portfolio of Warren Buffett's Berkshire Hathaway(NYSE: BRK-A)(NYSE: BRK-B). Specifically, because of Berkshire's amazing returns over the past 50 years, some incorrectly assume that Buffett hit a few "home runs" -- tech stocks in the 80s, perhaps. However, Berkshire's stock-picking success has mainly been due to good (not amazing) returns that were sustained over long periods of time.

With that in mind, there are several types of stocks Buffett and company tend to stay away from. Here are three examples, and the reasoning behind each.

Tech stocks and biotechs

While there are a couple of exceptions in Berkshire's current portfolio -- IBM and Apple -- Buffett generally doesn't invest in tech stocks. And the main reason is simple enough: Buffett doesn't understand most tech companies' business well enough to make an informed investment decision. The same can be said for many biotech companies: It's simply too difficult for most people without expertise in the field to properly evaluate these stocks as long-term investments.

Around the time of the dot-com bubble, investors were wondering why Buffett wasn't hopping on the bandwagon, so he offered two more specific reasons for avoiding tech. First, he pointed out that tech companies tend to have limited "moats." A wide moat refers to a durable competitive advantage that preserves market share and facilitates profitability for years to come -- for example, Wal-Mart's wide moat is its size and distribution network, which allow it to sell items cheaper than its competition.

Second, Buffett correctly said it is extremely difficult to pick winners in the tech sector early on, and even more difficult to build a position at a reasonable valuation. As we saw in the aftermath of the tech crash, many of the valuations in the sector in 1999 and 2000 were simply ridiculous, even for the companies that stood the test of time.

IBM and Apple are exceptions because they have many other Buffett-stock qualities that make them solid, predictable investments. Even though Buffett didn't directly make the Apple investment, he has praised both companies' management throughout the years. Both companies also have tremendous financial flexibility, and a long-established record of profitability. And, both have a "wide moat." If you're interested, here are discussions about why Berkshire has IBM and Apple in its portfolio.

Companies with big capital needs, but low profit potential

As Buffett said in his 2007 letter to shareholders, "The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money."

Many tech companies fall into this category, as do many of the young companies I'll discuss in the next section. However, Buffett offered one specific example in that letter: airlines. Buffett pointed out that a durable competitive advantage (wide moat) has been elusive in the airline industry since the beginning, and that the demand for capital is never-ending.

He discussed the example of when Berkshire bought U.S. Air preferred stock in 1989, only to see the company face tremendous financial difficulty and stop paying the dividend. Berkshire was luckily able to get out of the investment at a profit in 1998, but over the next decade, the company went bankrupt twice. Common shareholders weren't so lucky. To this day, airlines have been notably absent from Berkshire's stock and subsidiary portfolios. (Note: Berkshire does own NetJets, but that isn't an airline in the traditional sense.)

As a counterexample, consider See's Candies, a Berkshire subsidiary. When Berkshire bought See's in 1972, the company's pre-tax profits were about $5 million, and $8 million in capital was needed to run the business. By 2007, See's profits had grown to $82 million for the year, with a capital requirement of just $40 million. In fairness, Buffett points out that See's is an exception to the rule -- companies with this level of growth typically need about $400 million in capital investment to achieve similar results.

My point is not to comment on the current investment merit of airline stocks. Rather, the point is that when you make an investment, there should be reasonable capital demands, significant profit potential, and an identifiable durable competitive advantage. As an investor, you can compare companies' returns on invested capital (ROIC) in order to assess whether or not capital requirements are justified by the profitability.

Young companies

In the tech discussion, I mentioned how Buffett found these companies difficult to analyze early on. Well, the same logic can be applied to virtually any new, untested company. This is why you'll never see Buffett invest in companies like Tesla or Netflix. These businesses may end up doing great, but for now, they simply haven't had a chance to develop and mature long enough to produce the kind of consistent profits Buffett likes to see. If you look at Berkshire's portfolio, it's tough to find any companies that haven't been around for several decades.

On a related note, I can't emphasize enough the value Buffett places on a company's management. Buffett believes good management can literally add billions to the intrinsic value of a company, and that poor management can make a business undesirable from an investment standpoint. With newer companies, there is simply no way to know if the managers are shareholder-friendly and fiscally responsible.

You can apply these lessons to your own investment choices

While I'm not necessarily telling you to stay away from stocks of new companies such as Tesla and Netflix if you believe in them for the long term, there are still some valuable lessons to learn from the stocks Buffett doesn't like to invest in. The idea that you shouldn't invest in what you don't understand is a great example. Personally, I have a strong understanding of banking, real estate, and energy, so stocks of those types of companies make up the bulk of my portfolio. Biotechnology and retail -- not so much.

The bottom line is that knowing what not to buy is one of the most important long-term investing lessons you can learn, so instead of focusing on the individual stocks billionaires are purchasing, take some time to notice what they aren't adding to their portfolios.

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RELATED: Warren Buffett through the years

Warren Buffett through the years
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Warren Buffett won't buy these 3 types of stocks
Investor Warren Buffett answers reporters' questions during a press conference to announce that Walt Disney will buy Capital Cities/ABC July 31.
Billionaire investor Warren Buffett of Omaha makes a rare public appearance during an autograph session outside Borsheim's Jewelry Store in Omaha, May 4. Buffett was signing autographs for shareholders in his company, Berkshire Hathaway, which is having its annual meeting May 5.
Billionaire businessman Warren Buffett sits with his wife Susan (R) and daughter Susie, prior to the annual Berkshire Hathaway shareholders meeting in Omaha, May 5. This marks a rare public appearance for the reclusive Buffett.
Arnold Schwarzenegger, Republican candidate for governor of California in the October 7, 2003 recall election listens as world famous investor, Warren Buffett (L), one of his financial advisors, speaks to reporters after a meeting of Schwarzenegger's Economic Recovery Council in Los Angeles August 20, 2003. REUTERS/Fred Prouser FSP
Billionaire financier Warren Buffett looks on after a meeting with U.S. Senator Arlen Specter (R-PA) and chairman of the Senate Judiciary Committee, at the Hart Senate Office Building on Capitol Hill in Washington June 29, 2005. Specter is the co-author of a bill seeking to create a $140 billion asbestos compensation fund. REUTERS/Shaun Heasley SH/TC
Billionaire Warren Buffett arrives at the Sun Valley Resort in Sun Valley, Idaho July 10, 2007. The world's biggest media chiefs gather this week at the 25th annual Allen & Co. conference at the resort starting today. REUTERS/Rick Wilking (UNITED STATES)
Warren Buffett, chairman and CEO of Berkshire Hathaway, speaks at a Senate Finance Committee hearing about "Federal Estate Tax: Uncertainty in Planning Under the Current Law" on Capitol Hill in Washington, November 14, 2007. Billionaire Buffett warned of widening U.S. income disparity and endorsed the estate tax as a check on wealth accumulation, while two senior lawmakers said they want the tax repealed. REUTERS/Jason Reed (UNITED STATES)
Billionaire financier and Berkshire Hathaway Chief Executive Warren Buffett greets shareholders during the Berkshire Hathaway Annual Shareholders meeting in Omaha, Nebraska May 3, 2008. REUTERS/Carlos Barria (UNITED STATES)
Billionaire investor Warren Buffett laughs as he appears with Microsoft Corporation founder Bill Gates for a town hall style meeting with business students broadcast by financial television network CNBC at Columbia University in New York, November 12, 2009. REUTERS/Mike Segar (UNITED STATES BUSINESS)
Berkshire Hathaway Chairman Warren Buffett kisses his ukulele at the Berkshire Hathaway annual meeting in Omaha May 1, 2010. Buffett played "I've Been Working on the Railroad." REUTERS/Rick Wilking (UNITED STATES - Tags: BUSINESS TRANSPORT)
Billionaire financier and Berkshire Hathaway Chief Executive Warren Buffett (L) and Microsoft founder Bill Gates gesture at the national launch ceremony for the BYD M6 vehicle in Beijing September 29, 2010. Chinese battery and car maker BYD, backed by Buffett, launched its first premium multi-purpose vehicle (MPV) in Beijing on Wednesday to tap rising demand in the world's biggest auto market. REUTERS/Jason Lee (CHINA - Tags: TRANSPORT BUSINESS)
Billionaire Warren Buffett, wearing a traditional tikka or a red mark on the forehead, speaks during a news conference in Bangalore March 22, 2011. Buffett on Tuesday said he is looking to invest in large countries like India, China and Brazil, but added that restrictions on foreign ownership in India's insurance industry could be a deterrent. Buffett also said and the U.S. economy was improving and that the devastating earthquake in Japan would not hurt global growth. REUTERS/Stringer (INDIA - Tags: BUSINESS)
Berkshire Hathaway Chairman Warren Buffett tours the floor of the New York Stock Exchange September 30, 2011. REUTERS/Brendan McDermid (UNITED STATES - Tags: BUSINESS)
Berkshire Hathaway chairman Warren Buffett holds his hand over his heart during the singing of the national anthem, at the start of a 5km race sponsored by Brooks Sports Inc., a Berkshire-owned company, in Omaha May 5, 2013, a day after the company's annual meeting. Buffett at the meeting on May 4, 2013 gave the most extensive comments to date about the future of Berkshire Hathaway Inc after he is gone, saying he still expects the conglomerate to be a partner of choice for distressed companies. REUTERS/Rick Wilking (UNITED STATES - Tags: BUSINESS SPORT ATHLETICS)
Warren Buffett, Chairman of the Board and CEO of Berkshire Hathaway, poses for a portrait in New York October 22, 2013. REUTERS/Carlo Allegri (UNITED STATES - Tags: BUSINESS)
Roberta Buffett Elliott sits with her brother Warren Buffett as they attend an announcement ceremony at Northwestern University in Evanston, Illinois, January 28, 2015. The sister of financial investor Warren Buffett has given Northwestern University more than $100 million to create the Roberta Buffett Institute for Global Studies, the largest single gift in the school's 164-year history, the university said on Wednesday. REUTERS/Jim Young (UNITED STATES - Tags: BUSINESS EDUCATION SOCIETY)
Warren Buffett, chairman and CEO of Berkshire Hathaway, speaks at the Fortune's Most Powerful Women's Summit in Washington October 13, 2015. REUTERS/Kevin Lamarque/File Photo
Warren Buffett, chairman and CEO of Berkshire Hathaway, smiles before speaking with Bill Gates (not pictured), at Columbia University in New York, U.S., January 27, 2017. REUTERS/Shannon Stapleton

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