It can be tempting to invest in struggling businesses due to their potential to deliver a successful turnaround.
For example, they may have had a disappointing financial performance in recent years, meaning they offer a low valuation relative to sector peers. Investors may believe they can deliver improving financial returns, perhaps due to a change in management or a new strategy, that could equate to high share price growth.
However, elevated levels of risk come alongside their relatively high reward prospects. Companies that are struggling financially may continue to do so for many months, or even years. Indeed, some businesses that were dominant in their industry have folded over the years. This leaves their investors with large losses and significant opportunity costs.
Buffett’s view
Therefore, it may be logical to invest in sound companies that are delivering impressive financial performances on the back of clear competitive advantages over sector rivals. They may also offer far less risk than turnaround opportunities and could still provide attractive returns over the long run.
Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) Chairman Warren Buffett (Trades, Portfolio) has been an advocate of this strategy for many years.
“After 25 years of buying and supervising a great variety of businesses, Charlie (Munger) and I have not learned how to solve difficult business problems. What we have learned is to avoid them,” he said.
Clearly, more attractive businesses facing fewer obvious challenges are likely to command higher valuations versus turnaround prospects. This may dissuade some investors from buying them because of a perceived lower return profile.
However, as Buffett’s success over recent decades has shown, paying a fair price for a high-quality company can be preferable to buying cheaper shares in relatively unattractive businesses. They may offer a more reliable return that, when compounded over the long run, proves to be more attractive than the gains of even the most successful turnaround opportunities.
A selective approach
Of course, Buffett’s approach could mean investors become increasingly selective when choosing which stocks to buy. They may struggle to unearth companies that do not face obvious challenges–especially if they have a relatively limited sphere of knowledge that means they are comfortable investing in only a limited number of sectors– leading to significant frustration.
However, investors do not necessarily need to buy a large number of stocks to generate high portfolio returns during their lifetime. Indeed, a small number of companies, such as Coca-Cola (KO, Financial) and American Express (AXP, Financial), have been prominent holdings for Berkshire Hathaway for many decades and have driven the company’s outperformance .
Therefore, a strategy of being highly selective, in terms of avoiding stocks that could prove to be problematic, could be a prudent approach. It may raise the bar for entry into an investor’s portfolio that permits them to only invest in the most attractive risk-reward opportunities.
