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The Three Types of Businesses That Buffett Will Not Touch...

Jun 22, 2016

In this issue:
» India lags in attracting foreign investments
» Structural reforms in the financial sector urgently needed
» ...and more!
00:00
Radhika Pandit, Managing Editor of ValuePro

Given the kind of wealth Warren Buffett has amassed over the years, one can never really tire of analysing and discussing the stocks in the Berkshire portfolio.

Reams of articles can be written on Buffett's star stocks - Coca Cola, American Express, Wells Fargo, Walmart, etc. These stocks multiplied Buffett's wealthcha over time, so investors naturally want to understand what sets them apart.

But dissecting Buffett's investments is just one to gauge the Oracle of Omaha's road to riches. It is equally important to understand the companies that Buffett decides not to invest in.

This gives a holistic view of stock picking: We need to know not only what to buy but what not to buy.

So what kind of companies does Buffett not like to buy?

The Motley Fool recently wrote on this topic. Let's take a look.

Capital intensive companies with low profit potential

There is nothing like an opportunity to invest in a 'great' business - a business with a strong moat or competitive advantage that not only generates excellent returns on capital but does so with low capital requirements.

But great businesses are not always easy to find. And if in the process one comes across a 'good' business, there's no harm investing in it provided the returns on capital are still decent.

Now, the businesses to shun are what Buffett calls 'gruesome' businesses. These are companies that require a lot of reinvestment yet generate little or no cash.

Buffett explains it like this:

  • Think of three types of 'savings accounts'. The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.

Airlines are a classic example of gruesome businesses. Capital requirements are high. Too many factors are beyond the management's control. And for all that, most of them consistently report losses.

Young companies

Buffett has always been wary of investing in companies that have just started operations.

The reason for this can be easily explained. Buffett likes to invest in companies that have an established record of consistent profits.

New companies, then, do not fit the bill. It is too difficult to analyse young, untested companies and take a call on whether they have what it takes to evolve into strong, mature organisations.

This doesn't mean one must shun young companies altogether. It depends on the risk you are willing to take and how comfortable you are with the business. Buffett stays away from young companies because it's too difficult for him to take a call on the sustainability of their business.

Tech and biotech companies

This is an interesting one. Buffet is famously averse to investing in tech stocks. The reason is simple: Since the tech sector is continuously evolving, he can't foresee the amount of free cash flow tech companies will generate in five or ten years.

Same for biotech companies: Without expertise in the field, it's too difficult to properly evaluate these stocks as long-term investments.

Once again, it is all about sticking within your circle of competence. If you do not understand the dynamics of a sector and the stocks within it, do not invest in them. Even if they're the hottest stocks around.

Buffett's philosophy has stood him in good stead and helped him avoid burning his fingers when the dot com bubble burst.

And yet, he recently invested in two tech companies: IBM and Apple. Why?

One obvious reason is that he believed they were undervalued. But it is interesting to note that he didn't invest in IBM and Apple in their early days.

He tracked them over the years, was convinced of the strength of their management, and was impressed by their long-established record of profitability. So when both these companies were available at reasonable valuations, Berkshire went ahead and took the plunge.

My ValuePro team and I do a similar kind of exercise when evaluating stocks we want to include in our two ValuePro portfolios.

We, of course, explain in detail why we think certain stocks meet all the 'Buffett-would-buy' criteria.

Those that are trading at attractive prices make their way into the portfolio.

We still like the ones that we don't recommend. It's just that we aren't comfortable with the valuations, and believe investors should buy them only when the prices correct a certain amount.

But my team and I also think it's important to look at businesses that Buffett wouldn't invest in because they fail to meet one or two of his strict criteria. And yet, they are not bad or terrible businesses. Why don't they make the cut for ValuePro then? What do they need to do be considered strong ValuePro Contenders?

These are ideas and questions that we evaluate and answer every month and bring it to the attention of our subscribers and readers.

Do you also try to avoid companies Buffett wouldn't invest in? Let us know your comments or share your views in the Equitymaster Club.


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03:01 Chart of the day

India has been attracting foreign investments thanks to the government's Make in India initiative and other reform measures. The country's FDI inflows rose by 26% to US$ 44 billion in 2015. Services continue to attract the largest investments riding on the wave of e-commerce and start-ups. But the employment generating manufacturing segment has lagged behind. Even globally, India ranks tenth in terms of the quantum of FDI inflows. This is reflected in the fact that the country's FDI accounts for a mere 2% of the GDP as compared to 5% for a smaller country like Vietnam. India's total FDI inward stock at US$ 282 billion is only a tenth of the combined FDI stock of China and Hong Kong.

Therefore, India still has miles to go before it attains the tag of the most favoured investment destination. In a positive move, the government has further relaxed the FDI norms in seven sectors including defence, pharmaceuticals, aviation and single-brand retailing. This is barely seven months after it had eased norms for foreign investments in 15 sectors. These liberalisation measures are likely to fuel growth in the economy in the long run.

India lags in attracting foreign investments


04:09

The World Bank has also stressed on the revival in private investments and rural demand in India for it to continue growing at over 7% in future. The World Bank in its 'India Development Update' report has said that private investments in India have hit a roadblock on account of excess global capacity, and corporate debt pileup. And these in turn have hit the banking sector's ability to finance in the backdrop of regulatory and policy challenges.

The World Bank has hinted at acceleration in structural reforms in the financial sector and resolution of the bad loan crisis as two key reform measures that need to be put on the fast track. The government and RBI have recently laid down a number of measures such as the Bankruptcy Code and the new Scheme for Sustainable Structuring for Stressed Assets (S4A) to empower banks in their fight against bad loans. These steps will go a long way in boosting the credit environment in the country once the economy revives.

4:45

Indian stock markets had a volatile trading session today as they oscillated to either side of yesterday's close. The BSE Sensex was trading lower by 60 points (0.2%) at the time of writing. Losses were largely seen in auto, and FMCG stocks. The BSE Midcap and the BSE Smallcap were not spared either as both were trading in the red at the time of writing.

04:55 Today's investment mantra

"The future is never clear, and you pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the buyer of long-term values." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Radhika Pandit (Research Analyst) and Madhu Gupta (Research Analyst).

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