Masters Series: What Rich, Sophisticated Investors Know About Stocks That Poor People Do Not

Editor's note: In this weekend's Masters Series essays… we are sharing two fundamental secrets that  rich investors understand about stocks. Most individual investors don't grasp these ideas… which explains why most of them never make money in the market.

S&A's Dan Ferris, editor of The 12% Letter and Extreme Value, published these essays as part of a special report detailing five core concepts of successful long-term investing, "What Rich, Sophisticated Investors Know About Stocks That Poor People Do Not."

In today's excerpt, Dan explains how to tell a good business from a bad one. We hope you enjoy them. Tomorrow, he'll show you how to avoid a simple mistake that can guarantee your investments lose money…

What Rich, Sophisticated Investors Know About Stocks
That Poor People Do Not
By Dan Ferris, editor, The 12% Letter

In late 2011, my publisher Porter Stansberry asked me to write about a controversial topic.

He challenged me to write down what rich, sophisticated investors know about stocks... that poor people do not.

I know this is a controversial topic.

After all, most people aren't rich. The word "rich" often conjures up feelings of envy and resentment in people who don't have much money.

Also, nobody likes to be called a loser. But the average person is far more likely to lose money in the stock market than to make money. The numbers prove it...

Dalbar is a firm that tracks the "real world" returns of mutual-fund investors. Mind you, I'm not talking about the overall returns of the mutual funds themselves, but the actual returns investors make in them. These folks are a good representation of the average investor.

Dalbar's research shows that while stock mutual funds gained about 9% on average from 1991 through 2011, the actual return earned by the average investor was only 3.2%... which didn't even beat the rate of inflation during the period.

I'm sure you've heard some vague reasons why the "average guy" struggles in the market. He gets greedy near market tops. He gets too fearful near market bottoms. He struggles with his emotions.

Those are valid reasons. But I've found that many people struggle in the stock market because they fail to learn five basic ideas.

This essay is about those ideas. It's about sharing timeless wisdom successful investors have used for centuries.

If you have struggled in stocks over the past 20 years – or if you'd simply like to improve as an investor – I believe the ideas I'm about to share will be a huge help to you.

I didn't "invent" these ideas. Again, they've worked for centuries. They'll continue to work forever. If you take them to heart, chances are good you'll immediately start making great investment decisions.

A great investment lesson played out in the press in late 2011.

The mainstream outlets didn't put the puzzle together at all, so you might have missed it. But if you understand this lesson, 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."

The other part of the lesson was the news on November 29, when American Airlines filed for Chapter 11 bankruptcy. The company had lost $10 billion since 2001. As with almost all bankruptcies, it was 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 one of the keys to long-term investing success. And IBM and American Airlines provide excellent examples of each.

We'll start with the bad... American Airlines needed to go bankrupt so it could reduce its debt burden and remain competitive with airlines 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 in 2011 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, declared bankruptcy in December 2011 and had to merge with USAir just to remain in existence. It's hard to run a great airline business.

Even Buffett has a hard time avoiding these 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.

But Buffett prefers to focus on buying the world's best businesses. That includes Coke, Wal-Mart, and Johnson & Johnson… And now it includes 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 problems airlines do. 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 earns $15 billion of free cash flow every year and does around $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 – 2001-2011 – IBM rose about 6% a year. The S&P 500 returned less than 1% a year. American Airlines, of course, was 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 Ferris

Editor's note: Identifying great businesses is one of five investing concepts Dan explains in his special report, "What Rich, Sophisticated Investors Know About Stocks That Poor People Do Not."

Dan uses these investing concepts to help him identify safe, income-producing stocks for his 12% Letter subscribers. He recently showed readers how to build a substantial, high-income retirement portfolio on just "$1.10 a day." To learn more about The 12% Letter and access his "Rich Investors" report, click here.