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Two Easy Ways to Lose Your Money

Charlie Munger, the famous side-kick of billionaire investor Warren Buffett, is famous for his investing wisdom. But there’s one quote of his that I find particularly insightful: “Tell me where I’m going to die, that is, so I don’t go there.”

When applied to investing, it simply means that we should be focusing on ways to not lose money rather than on ways to shoot for the sky.

So, here are two easy ways for investors to lose their money in the stock market. Avoid them, and chances are your portfolio would be thanking you for it in the future.

1. Finding a ‘Gruesome’ business model

In Buffett’s 2007 Berkshire Hathaway shareholder letter, he shared the essential characteristics of the kinds of business he would not touch with a 10-foot barge pole. He calls these “gruesome” businesses and here’s how he describes it:

The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favour by shooting Orville down.”

To be fair, not every airline has proven to be a bad investment. For instance, shares of the American budget carrier Southwest Airlines has gained more than 1,700% in price since the start of 1984 some 20 years ago. Meanwhile, the American market, represented by the S&P 500 Index, only managed a 1,000% gain.

But still, if you would like to really maximise your odds of not picking big losers, then you’ll do wise to steer clear of companies with a need for massive capital investments but yet earns little on those investments.

A comparison between commercial inspection and testing firm Vicom (SGX: V01), which requires relatively little cash reinvestment, and full-service carrier Singapore Airlines (SGX: C6L), can showcase the important differences.

Vicom

Singapore Airlines

10-year average of ratio of Capital Expenditures to Sales

6.8%

16%

Total change in profits over past 10 completed financial years

355%

-64%

Change in share from Jan 2004 till now

542%

-12%

Source: S&P Capital IQ

SIA, as a business, displayed the ‘gruesome’ hallmarks that Buffett described. It required significant capital to be reinvested into the business as it has to spend a large amount of its sales as capital expenditures and it earned little or no money as exemplified by the fall in its profit.

Vicom, on the other hand, required much lesser amounts of capital and at the same time, displayed growing profitability. The difference in the quality of their businesses became apparent over the years, and eventually gets reflected in their share price returns.

Bear in mind though that this is by no means a recommendation of Vicom and that the company was used to illustrate how well a high return and capital-light business can perform in relation to a low return and capital intensive one (of which airlines are just one example).

2. Finding over-valued shares

Can you name one commonality between shipping firm Cosco Corp. (SGX: F83) and logistics and data centre service provider Keppel Telecommunications & Transportation (SGX: K11)?

Turns out both shares were very richly valued near the Straits Times Index’s (SGX: ^STI) peak of around 3,900 points that was reached on 11 October 2007 just before the Great Financial Crisis of 2007-2009 started.

Company

Share Price: 11 Oct 2007

Trailing PE Ratio

Cosco Corp.

S$6.90

58

Keppel T&T

S$4.70

57

Source: S&P Capital IQ

With such high valuations, there were plenty of high expectations built into the future performance of those two companies. When the eventual growth of those two shares turned out to be disappointments, the punishment was brutal.

Company

Change in earnings since then**

Change in share price

Cosco Corp.

-81%

-90%

Keppel T&T

40%

-62%

**Calculated by finding the percentage change between current earnings and earnings back then.

Source: S&P Capital IQ

All told, Cosco Corp and Keppel T&T were richly-valued shares that went on to do very poorly for its investors. That’s not to say however that expensive shares would necessarily make bad investments; richly-valued companies can go on to make good investments as well.

But again, to increase your chances of side-stepping investment land-mines, staying clear of exorbitantly-priced shares in relation to their underlying business fundamentals would be a good way to do so.

Foolish Bottom Line

The economist Erik Falkenstein once said that investing is very much like amateur tennis. In amateur tennis, players concentrate on reducing mistakes and not on making spectacular game-winning shots.

That’s just another way of framing Munger’s quote that I referenced at the start and carries pretty much the same spirit as the two most important rules that Warren Buffett himself uses when investing in the stock market:

Rule No.1 – Don’t lose money. Rule No.2 – Don’t forget the first rule.”

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns B-class shares of Berkshire Hathaway.