Warren Buffett won't buy these 3 types of stocks

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