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The Most Important Question You Should Ask When Investing

In investing, the most important question to ask isn’t “What’s great to buy now?” Instead, I think the question should be “What shouldn’t I buy now?” This stems from some really eye-catching statistics that J.P. Morgan recently released in a report titled “The agony & the ecstasy: The risks and rewards of a concentrated stock position”.

Here’re a few of those stats:

1. Nearly 40% of all stocks in the Russell 3000 (an American share market index comprised of the largest 3,000 US companies) universe since 1980 have suffered a permanent decline of more than 70% from their peak value.

2. Since 1980, 40% of all stocks in the Russell 3000 universe have delivered negative absolute returns over their entire lifetime as a publicly-listed entity (the “lifetime” returns of a share start from the date of its listing all the way till 2014 or the date at which it ceased to be a listed entity).

Given such a high prevalence of shares with devastatingly poor long-term returns, it shows that avoiding the losers might be even more important than picking the winners. This is also in line with Swedish economist Erik Falkenstein’s observation about the nature of investing:

“In expert tennis, 80% of the points are won, while in amateur tennis, 80% are lost. The same is true for wrestling, chess, and investing: Beginners should focus on avoiding mistakes, experts on making great moves.”

So, if avoiding mistakes in stock picking is that important, how should you go about doing it? Here’re some helpful pointers.

1. Avoid “gruesome” business models

Warren Buffett’s investing career has been about finding easy investments. “We get paid not for jumping over 7-foot bars but for finding 1-foot bars that we can step over,” he once said in Berkshire Hathaway’s 2003 Annual Shareholders’ Meeting.

To aid him in his quest in finding those 1-foot bars, Buffett tries to identify businesses with very poor economic characteristics. Once found, he then avoids them like the plague. Here’s how he describes such “gruesome” businesses in his 2007 Berkshire Hathaway shareholder letter:

“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.”

Of course, not every airline makes for a poor investment (Southwest Airlines was actually the best performing share ever in the USA in the thirty years ended 2002). But to maximise your chances of avoiding mistakes, Buffett’s take on “the worst sort of business” is well-worth noting.

A comparison between VICOM Limited (SGX: V01) and Singapore Airlines Ltd. (SGX: C6L) can be a good example.

Vicom SIA
10-year average for ratio of Capital Expenditures to Revenue* 7.32% 14.1%
Total change in profit over past decade* 271% -73%
Change in share price from 1 January 2004 till today 618% -9.8%
*For last 10 completed financial years

Source: S&P Capital IQ

Vicom had required relatively little reinvestment of cash (judging from its capital expenditure to revenue ratio) while still being able to earn a growing profit. Singapore Airlines, on the other hand, had fit Buffett’s description of a poor business almost to a tee; as an airline, the company had required much higher amounts of capital for reinvestment and yet could not translate that investment into higher returns.

The differences in the economic characteristics of Vicom’s and Singapore Airlines’ businesses eventually resulted in their markedly different share price gains since the start of 2004.

2. Avoid richly-priced businesses

Buying shares which are richly-priced in relation to their underlying business prospects can be a painful experience for investors. Shipping firm Cosco Corporation (Singapore) Limited (SGX: F83) and logistics and data centre outfit Keppel Telecom. & Transport. Ltd. (SGX: K11) are two such local examples.

When the Straits Times Index (SGX: ^STI) closed at its peak of 3,876 points back in 11 October 2007, the two shares – Cosco Corp and Keppel T&T – had carried very high trailing price-to-earnings (PE) ratios of 58 and 57 respectively. Today, with Cosco Corp’s earnings falling by 87% since then, its shares have followed suit with a 90% decline. Meanwhile, Keppel T&T’s profit did grow by 35% in total from October 2007 to today. But, that’s an anaemic compounded annualised growth rate of just 4.4% – that’s hardly enough to justify its high valuation back then. As a result, Keppel T&T’s shares have fallen by 64% since.

Foolish Bottom Line

These are of course not the only stock-picking mistakes investors should avoid. But, they can still be a great place to start when you ask the most important question in investing, “What shouldn’t I buy now?”

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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 shares in Berkshire Hathaway.