Why Warren Buffett avoids these 3 types of companies

Nearly all investors would agree that it’s more fun to talk about investment successes than failures.

However, your overall success as an investor in many ways has just as much to do with what you do right, as it does with what you do wrong!

For this reason, minimising your mistakes can have just as big an impact on your overall investment returns as your winning picks do.

When it comes to a great example of successfully minimising losses, one need look no further than legendary investor Warren Buffett.

Buffett, through his decades of shareholder letters and interviews, has not only provided insights into how to pick stocks, he has also provided insights into what to avoid.

Here are three tips from Buffett on the types of companies he recommends avoiding.

Tip 1

Stay within your ‘circle of competence’.

Having a deep knowledge of a particular company or industry can help minimise the chance of making a mistake as your investment decision will be more informed.

A classic example is arguably bank shares.

Many ASX investors own shares in the major banks such as Commonwealth Bank of Australia (ASX: CBA), yet how many of these shareholders really understand the bank’s financial accounts?

Terms such as capital adequacy ratio and Tier 1 capital are crucial to thoroughly understand, before investors should have even the remotest confidence of investing in bank stocks.

Buffett (of course) is an extraordinary investor and the banking business is certainly within his circle of competence; bank shares aren’t within all investors’ circle of competence however.

In contrast, Brambles Limited’s (ASX: BXB) business of renting out pallets and containers is relatively easy for many investors to understand. Likewise, its balance sheet and financial statement don’t have the financial leverage and complexities of a bank which makes the analysis of the company more manageable and straightforward.

Tip 2

Focus on businesses with a competitive advantage.

Buffett often talks about a company’s “moat” which is just another term for a company’s competitive advantage.

A moat can be created in different ways including through a brand – such as Bellamy’s Australia Ltd (ASX: BAL).

Alternatively, a monopoly position can form a moat. Transurban Group’s (ASX: TCL) operation of key toll road infrastructure assets is an example.

Businesses with moats are what Buffett favours, conversely, businesses which lack moats are what Buffett avoids.

The most commonly cited example by Buffett of an industry which lacks a moat is the airline industry. Qantas Airways Limited (ASX: QAN) would almost certainly be avoided by Buffett.

Tip 3

A third tip of Buffett’s is to avoid companies where management focusses on earnings before interest, tax, depreciation and amortisation (EBITDA).

The way Buffett sees it, EBITDA does not give a true account of the operating performance of a company because depreciation and amortisation are very real costs for any business.

A manager who chooses to focus on EBITDA is, in Buffett’s opinion, trying to gloss over these crucial expenses and portray an unrealistic picture.

In other words, Buffett wants management to be frank and honest with shareholders. An example of a management team that, in my opinion, doesn’t beat around the bush with its shareholders is Flight Centre Travel Group Ltd (ASX: FLT).

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Motley Fool contributor Tim McArthur has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. 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. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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