Why Buffett Doesn’t Invest In AIM Shares

Warren Buffett is one of history's most widely-quoted investors. And high on the list of popular Buffett quotes is the following gem: "The first rule of investing is don't lose money; the second rule is don't forget Rule No. 1."

It's a quote that's usually trotted out to highlight Buffett's investing performance. For while Berkshire Hathaway does lose money, it does so only very rarely. Between 1965 and 2006, for instance, Buffett experienced only one loss-making year: 2001.

What is often overlooked, though, is why Buffett is so keen to avoid losses. In short, it's not because he hates red ink -- it's because he understands all too well the impact of incremental losses on overall investing performance.

The Snowball

Here on The Fool, we've always been keen on the notion of compounding. In short, we believe that slow, steady, consistent returns build up over time into a hefty gain. It's why we're such fans of index trackers, for instance -- and of low-cost index trackers in particular.

Warren Buffett has much the same view of things. According to Buffett's official biographer Alice Schroeder, it's actually why her biography was entitled The Snowball. Snowballing, she explains, "is really a metaphor for compounding, for the way that things tend to grow at an exponential rate when they are rolling forward over time."

Because Buffett understands all too well that it's difficult to recover from losses. If your portfolio goes down by 50%, from that point it will then take a 100% percent return just to get back to where you were.

Safer bets

Which, in simple terms, is why Buffett likes big businesses: they're less volatile, and less likely to go pop. In Buffett's book, the investor should go for businesses that deliver outstanding returns on capital, which produce substantial cash profits, and which possess a huge economic 'moat' to protect them from competitors.

It's why, for example, his most recent high-profile purchase was of railroad company Burlington Northern Santa Fe Corp -- yes, all of it, at a price tag of $34 billion.

In short, Buffett buys great businesses, businesses that throw off substantial amounts of cash, and that happen -- ideally -- to be priced very attractively at the time of purchase. That way, his protection from losses is threefold:

• The businesses throw off cash, defraying his purchase price
• With a deep moat, he's protected from market and share price shocks
• As he's bought the business 'on the cheap', there's more upside than downside

AIM businesses don't often fit that description. They might be great businesses tomorrow -- but they're not great businesses today.

Finding tomorrow's great businesses

That said, Buffett doesn't always adhere to his own advice. If he did, I guess, he wouldn't be Buffett. Take his $230 million stake in Chinese battery company BYD, which is branching out into electric‑hybrid cars.

OK, by Buffet standards, that's chump change. And nor is BYD listed on AIM -- it's actually quoted on Hong Kong's Hang Seng. But that's not the point. What's at issue is that it isn't a great business today. It might be one tomorrow -- but it isn't yet.

But while I'm no fan of AIM's wilder shores -- speculative oil and mining ventures with uncertain corporate governance -- there's no denying that AIM does occasionally throw up businesses that have the potential to be great.

And, as it happens, two of them reported this week.

Asian Citrus Holdings

I wrote about Asian Citrus Holdings (LSE: ACHL) back in September, since when it's climbed by 80% and thrown off a decent dividend. So I won't repeat myself here.

Essentially, it's a play on the Chinese consumer, and a growing Chinese appetite for oranges and orange juice. And before you laugh, let me gently remind you of two of Buffett's biggest long term bets: Coca-Cola and Wrigley's, the chewing gum manufacturer.

Interim results, reported this week, looked good:

• Revenues up 36%
• Pre-tax profit up 65%
• EBITDA up 57%
• Basic EPS up 60%