What is the key to a lifetime of successful investing? People have all sorts of answers to that question, but I think that Warren Buffet's answer is the best:
An investor needs to do very few things right as long as he or she avoids big mistakes.
Speculating on a bunch of unproven companies can certainly lead to enormous gains if they make it big, but it can also lead to some truly staggering losses. Imagine two hypothetical investors. Investor A speculates and has some very good years and some very bad years. For three years in a row his portfolio is up 50%, but then in the fourth year he loses 70% to a series of big mistakes. This cycle repeats itself over Investor A's investing lifetime, about 40 years. Investor B, on the other hand, manages a 5% return each and every year for the full 40 years. Which investor does better in the end?
Given that 75% of the time Investor A manages a 50% return it would seem at first that he should blow away Investor B. But not so.
Because Investor A continually makes big mistakes his successes are almost completely canceled out. When you lose 50% of your portfolio you need a 100% gain just to get back to even, and this fact is working hard against Investor A. Investor B, on the other hand, never found the next big thing because he wasn't looking. Instead, he was consistent and avoided making the same mistakes which Investor A made. And at the end of 40 years time he was much better off for it.
How to avoid big mistakes
Warren Buffett talks a lot about moats, and for good reason. A moat is some kind of durable competitive advantage which allows a company to achieve above-average returns on capital in the long-term. Buying stock in companies with moats is generally a good idea, although overpaying for them can certainly lead to sub-par results. But they rarely lead to the horrifying results achieved by Investor A. And by the time they do it has typically been clear for a while that the moat has vanished.
Buying stock in companies that have no discernible competitive advantage can be fraught with danger. It can certainly lead to huge gains if the company is successful, but it can lead to huge losses as well. Take Groupon Inc (NASDAQ:GRPN), for example. The company partners with businesses to offer coupons for discounts on products and services, and was the first of the "daily deal" sites to gain prominence. Groupon Inc (NASDAQ:GRPN) IPO'd in 2011 at $20 per share, valuing the company at $15 billion at the time. The company had yet to turn a profit, but revenue was growing fast.
The problem with Groupon Inc (NASDAQ:GRPN) is simple: what do they do than couldn't easily be copied? There are now a slew of daily deal sites that offer essentially the same thing as Groupon Inc (NASDAQ:GRPN), and although Groupon Inc (NASDAQ:GRPN) is the best known there's no reason to believe that this will translate into profits. Fiscal 2012 saw more losses, although the trend appears to be positive.
Now, I'm not saying that Groupon Inc (NASDAQ:GRPN) is necessarily doomed, or that it will never turn a profit. But paying $15 billion for a company that had never turned a profit and operates in an ultra-competitive industry in which it enjoys no competitive advantages is a very Investor A type of thing to do. And since the IPO the stock has declined to about $6 per share, although it traded for as low as $2.60 last year. That's a loss of 70% in just a couple of years.
The problem with companies like Groupon is that they're impossible to value. Its business model could very well change over the next decade, and trying to predict anything about the company is a waste of time. Investor A got a little carried away when he was able to save $4 on a burger and fries and decided that Groupon was the next big thing. It wasn't, and it likely never will be.
Another good example is Zynga Inc (NASDAQ:ZNGA). Zynga Inc (NASDAQ:ZNGA) makes games for Facebook Inc (NASDAQ:FB) and mobile platforms, with popular games including the Farmville series and Words With Friends. Zynga Inc (NASDAQ:ZNGA) IPO'd around the same time as Groupon, and the number of people playing Zynga Inc (NASDAQ:ZNGA) games was growing fast. Initially priced at $10 per share a few months later it had increased to over $14 per share. Then, it tanked. It now trades at about $3.20 per share after reaching a low of $2.09 per share last year. That's a loss of nearly 70% from the IPO price.
Mobile games were and still are all the rage, but with most games either free or just a few dollars it's hard to imagine the profits really flowing. Zynga Inc (NASDAQ:ZNGA) uses the "freemium" model, where games are free but in-game content costs real money, and in 2010 the company managed a profit. But since then the losses have piled up.
Zynga Inc (NASDAQ:ZNGA) operates in a hyper-competitive industry, much like Groupon. It's far easier to make a game for Android or iOS than it is for game consoles or the PC, and this has brought on an almost uncountable number of competitors. And since most of Zynga's users don't pay the company a dime, the huge user base means little in terms of profitability. Unlike a popular console game that sells for $60 and sells millions of copies, people are generally unwilling to pay very much for a phone-based game.
There's just no reason to believe that Zynga has any competitive advantages at all. The company needs to constantly churn out ultra-popular games in order to be successful, and with the enormous amount of competition the business model seems unsustainable. Zynga is getting into the world of online gambling, which if successful could turn the company around, but the odds seem to be pointing the other way.
An alternative to bad decisions
Don't be like Investor A. Invest in high-quality companies that have some kind of competitive advantage. One company I like is Kraft Foods Group Inc (NASDAQ:KRFT), maker of packaged food and beverages. With strong brands such as Oreo, Philadelphia Cream Cheese, Ritz, Cadbury, Maxwell House, Trident gum, and the namesake Kraft Foods Group Inc (NASDAQ:KRFT) brand, the company holds an enviable position in the packaged food business. Kraft clearly has a competitive advantage, and it shows with strong cash flows and a nearly 4% dividend yield. Ten years from now Kraft will still be selling these products, and people will still be buying them. The same can not be said for the above two companies.
Kraft is part of my Ultimate Dividend Growth Portfolio, which you can track here. With an outstanding dividend yield and exceptional dividend growth prospects Kraft looks like a safe, reliable stock to hold for many years to come.
The bottom line
An investor can achieve life-long success by simply avoiding big mistakes. Investing in unproven companies that operate in ultra-competitive industries with no competitive advantages is a recipe for disaster. Investor A never learned that lesson, and after 40 years he wasn't much better off than when he started. You can do better.
The article Avoiding Big Mistakes Is the Key to Success originally appeared on Fool.com and is written by Timothy Green.
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