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Buying These 2 Stocks May See You Commit A Warren Buffett Investing Mistake

The 85 year old Warren Buffett is one of the best investors the world has seen. But, that does not mean he has a 100% strike-rate when he invests. In fact, he has made his fair share of mistakes over the decades that he has been investing professionally.

Admirably, Buffett has never shied away from publicly acknowledging his mistakes and that’s a great thing for all investors as we can then get to learn from him. In his 1989 Berkshire Hathaway shareholder’s letter, Buffett had shared one of his mistakes. He wrote:

“My first mistake, of course, was in buying control of Berkshire. Though I knew its business – textile manufacturing – to be unpromising, I was enticed to buy because the price looked cheap. Stock purchases of that kind had proved reasonably rewarding in my early years, though by the time Berkshire came along in 1965 I was becoming aware that the strategy was not ideal.

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the “cigar butt” approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original “bargain” price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen.

Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre.”

As Buffett had explained, it can be a mistake for an investor to focus solely on how cheap a stock is in relation to its assets. A cheap stock with a low quality business can still be a lousy long-term investment as it will not be able to compound value for its shareholders.

With the Straits Times Index’s (SGX: ^STI) 21% decline since the start of 2015, it’s a sign that there are likely to be plenty of cheap stocks out there. But, like Buffett warned, not all of them will be bargains. Here are two cheap stocks – with their very low multiples to book value – that may just be companies with poor businesses: Shipbuilder Cosco Corporation (Singapore) Limited (SGX: F83) and water-treatment firm Hyflux Ltd (SGX: 600).

Cosco and Hyflux PB ratio table
Source: S&P Global Market Intelligence (click table for larger image)

There are many ways investors can slice and dice a company’s fundamentals to assess the quality of its business. But in here, I’d focus on just two metrics: The return on equity and operating cash flow.

Chart 1 illustrates the returns on equity for Cosco and Hyflux over their last three completed fiscal years. What you can see is that the highest returns on equity that both companies had produced over the period we’re looking at is a mere 7.1% – that’s a poor performance.

Chart 1 - Cosco and Hyflux's returns on equity
Source: S&P Global Market Intelligence (click chart for larger image)

The next chart below plots Cosco and Hyflux’s operating cash flow over the same period as Chart 1. And as you can tell, both companies had been generating negative operating cash flow in the timeframe under study.

Chart 2 - Cosco and Hyflux's operating cash flow
Source: S&P Global Market Intelligence (click chart for larger image)

Generally speaking (bearing in mind that there are always exceptions), companies with attractive economic characteristics and quality businesses tend to produce high returns on equity and are adept at generating copious amounts of cash flow. We’ve just seen that Cosco and Hyflux lack these traits lately.

A Fool’s take

Given their low valuations, both Cosco and Hylfux may still turn out to be legitimate bargains. But given their recent low returns on equity and lack of cash flow, there’s also a chance that investors who are investing in the two companies at the moment may be making the same sort of mistake – of investing in a cheap company with poor business economics – that the venerable Buffett had made in the past.

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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.