A great lesson in investing played out in the press recently…

The mainstream outlets didn’t put the puzzle together at all, so you might have missed it. But if you understand and take this lesson to heart, you’ll be ahead of 99% of your fellow investors.

Let me connect the dots for you…

The first part of the lesson came on November 14, with news that Warren Buffett, CEO of Berkshire Hathaway and one of the world’s greatest investors, paid more than $10 billion to buy around 5% of big technology company IBM. Buffett simply said, “I felt that IBM had a very good business.”

[ad#Google Adsense 336×280-IA]The other part of the lesson was the news on November 29, when AMR Corp. (better known as American Airlines) filed for Chapter 11 bankruptcy. The company has lost $10 billion since 2001. As with almost all bankruptcies, it’s likely common shareholders will get nothing.

Here’s the lesson: You should buy good businesses and avoid bad businesses.

It sounds simple. And it should be. But what, exactly, makes a good business or a bad business? Knowing that is the key to long-term investing success. And IBM and American Airlines provide excellent examples of each.

We’ll start with the bad… American Airlines needs to go bankrupt so it can reduce its debt burden and remain competitive with United and Delta – both of which have been through bankruptcy and mergers.

It seems the only way to stay in the airline business is to declare bankruptcy. That’s because airlines are bad businesses.

Before you can sell one ticket, you need airplanes and all kinds of machines and people to keep the planes loaded and functioning. You also need to deal with unions. You need to borrow huge sums of money. And you need to compete on price with a dozen other airlines. You really don’t have any pricing power as an airline. The cost of fuel can rise at any time and eat into profits.

All those factors pushed American Airlines to consistently produce net losses. Its operating margin last year was a measly 1.4%.

Bad businesses – like airlines – must consistently spend money. But because of circumstances outside their control, they can’t consistently earn it. That’s why American Airlines, like so many airlines before it, is going bankrupt. It’s hard to run a great airline business.

Even Buffett has a hard time avoiding bad businesses. He’s lost money on airline stocks before. He joked years ago that there should be a hotline where the operator could “talk him down” if he was ever tempted to invest in an airline again.

Instead, Buffett prefers to buy the world’s best businesses. That includes Coke (NYSE: KO), Wal-Mart (NYSE: WMT), and Johnson & Johnson (NYSE: JNJ), all of which you’ve seen me write about before. And now it includes IBM (NYSE: IBM), as well…

IBM is the go-to provider of services to information technology departments of companies all over the world. It doesn’t need to spend huge amounts of capital to buy expensive machinery.

To run its business, all IBM needs to do is simply hire skilled people and give them the tools they need to keep in good working order the rat’s nests of computers and wires that power the world’s biggest firms. It doesn’t need to worry about what the price of copper or oil is doing.

Also, Buffett noted, IBM’s customers rarely jump ship for a competitor. They tend to stay put, giving IBM a big competitive advantage. It doesn’t need to worry so much about offering the lowest price.

In short, IBM doesn’t have to deal with any of the worst parts of American Airlines’ business. And you’ll see what that means in IBM’s financial results…

It has consistently thick profit margins: gross margins around 45%, net margins of 12%-14%. Its operating margin was 20% last year. It gushes cash. IBM earned $15 billion of free cash flow last year and just shy of $100 billion in sales. That’s $0.15 in free cash flow for every $1 of sales. And compared to its earnings, its debt is tiny. Last quarter, net income covered its interest payments 35 times over.

During one of the worst periods in stock market history – the last 10 years – IBM has risen about 6% a year. The S&P 500 has returned less than 1% a year. American Airlines, of course, is down 97% during that period, due to the bankruptcy filing.

Over the long haul, great businesses beat the market while exposing you to less risk than you get with most stocks… and they sure beat the heck out of losing money in bad businesses.

In short, avoid airlines and other lousy businesses. Buy very good businesses. It’s a simple formula. Most folks don’t have the know-how or the discipline to follow it, but that’s the surest strategy to making money in stocks over the long term.

Good investing,

Dan

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Source: Daily Wealth