For the vast majority of investors that are not sophisticated professionals performing rigorous analysis, one simple rule will keep you invested and compounding money for a long time: Focus on the balance sheet and avoid companies with anything more than modest leverage or debt.
Here's why: Debt can make very smart people look stupid, very quickly. Even the best investors, if they are caught up in situations with too much debt, can be humbled.
Go back to 2008 and very smart people were betting on financial firms (think Countrywide, CompuCredit, Bear Sterns, etc.) because prices had gotten so battered. What they seemingly forgot is that debt cares nothing about equity holders and too much debt will drive equity down to zero.
Too much debt will have the same effect on many energy-related stocks. Some very smart investors -- folks I would not bet against, like Prem Watsa at Fairfax Fianncial -- have stakes in names such as SandRidge Energy (SD), which I'm very interested in but just can't get over the leverage factor.
If it weren't for its size and high-quality asset base, Chesapeake Energy (CHK) could be in worse shape than it is now. But size enables operational efficiency that smaller players can't replicate.
John Maynard Keynes remarked that the market can stay irrational longer than you can stay solvent. While Keynes was addressing his comment to investors, his sage warning applies to businesses as well.
A year ago, no was predicting $40 oil, especially not the oil companies that were borrowing and drilling as much as they could. Now that $40 oil is here, oil prices can remain at that level longer than many companies will be able to remain solvent.
The late great value investor Walter Schloss, who had a successful investment career exceeding over 50 years, avoided debt like the plague. I had the rare privilege of hearing Schloss several years ago in a very private setting where there were less than 10 of us in attendance. I will never forget his repeated advice: "Just avoid debt."
Debt can turn a great company into an ugly investment seemingly overnight. Yet an inferior company that is debt-free or cash-rich has various levers it can use to become a great investment.
Too much debt can act like an addictive drug. Avoid the debt in your investment life and your portfolio is likely to avoid any significant catastrophes.