Dangerous Stocks That Will Burn Investors

For years, Warren Buffett has focused on finding the strongest companies with the best competitive positions and buying them when they're cheap. It's a strategy that's made him billions and one that's perfectly suited to today's market.

After all, these days, you can buy many of the best companies in the world for less than their fair value. You just need to be brave enough to face the volatility.

But ironically, the biggest risk to this strategy isn't the daily volatility -- if a company's truly strong, it will be able to survive even if we double-dip. The real risk is buying a company whose competitive position is weaker than it appears or is weakening.

Deceptively weak barriers
Often, a business seems to have strong barriers against competition simply because it has a well-known brand and large market share. In markets where there are significant economies of scale, such as many manufacturing or distribution businesses, market share can be a huge barrier. But if the economies of scale are relatively insignificant, a competitive advantage due to market share can be far weaker than it appears.

Take Charles Schwab (Nasdaq: SCHW  ) . It has a good brand name and billions in assets under management, but its revenue last year was below its level in 2000. A major problem is that there are few barriers to entry to creating an online brokerage.

Interactive Brokers and thinkorswim have both made big splashes in the last few years by offering superior trading technology, while E*TRADE (Nasdaq: ETFC  ) has also expanded its brokerage business significantly.

If Schwab truly had a huge moat, these competitors would have had a difficult time gaining any traction. Thus far, thanks to the brand and stickiness of assets under management, Schwab has actually been able to grow its margins, but it's unclear how long that will last with increasing competition.

Times change
Sometimes even the best positioned company can weaken over the course of years as what was once an unassailable moat becomes little more than a puddle.

This is true of most media businesses today. The impact of fewer people reading newspapers has been obvious for years as advertising dollars have fled from papers to search giants Google, Yahoo!, and MSN. But societal changes are impacting television networks as well. CBS (NYSE: CBS  ) has had declining revenue for years. If you exclude the effects of the Olympics and acquisitions, General Electric's (NYSE: GE  ) NBC unit has had limited growth. The world is changing, and it's hurting both these networks.

While TV viewing is at all-time highs, couch potatoes have more channels than ever before, meaning the market is more fragmented. The rise of Internet television only increases market fragmentation. As if that weren't enough, personal video recorders (PVRs) and file sharing networks have made much easier for consumer to skip commercials. These changes will result in lower ad rates and weaken the competitive position of TV networks.

Watch out for technology
It's no coincidence that the new technology is playing a big role in weakening the TV networks. Game-changing technology is one of the biggest risks that a company can face, and that risk isn't limited to high-tech businesses. Even a low-tech business like storage can be affected.

For decades, Iron Mountain (NYSE: IRM  ) built a boring business with a huge moat -- storing records for doctors, lawyers, and anyone else who generates a lot of paper. However, with more data being stored electronically -- including America's transition to electronic medical records -- the need for paper storage should decline. This trend isn't happening quickly, but it seems inevitable.

Iron Mountain recognizes the risk and isn't just sitting back. It's working on electronic record storage and has allied itself with IBM and Hitachi. But, it's still to be determined if the company will achieve the same dominance as it enters a new arena populated by tough, experienced competitors like EMC (NYSE: EMC  ) and Oracle (Nasdaq: ORCL  ) .

So, when looking at beaten-down blue chips, be particularly aware of the technological threats to the business. The Internet isn't cutting-edge technology anymore, but it's only becoming apparent now how it's gradually eroding the moats of many businesses.

The Foolish bottom line
That said, this doesn't mean that that you should never buy any company whose moat has weakened. Even from an eroding competitive position, sometimes blue chips can generate cash for decades.

Other times, when you see a stock in a terribly disadvantaged competitive position facing severe operational difficulties, you may have identified a strong short candidate that you can use to profit from its downfall or hedge other positions in your portfolio.

While shorting isn't for everyone, using a portion of a portfolio for selective shorting can serve many investors well. My fellow Fool John Del Vecchio -- a CFA and leading forensic accountant -- has put together a special report, "5 Red Flags -- How to Find the Big Short," that looks at some of the top ways to find short-worthy companies. Enter your email in the box below, and I'll send you John's report for free.

This article was originally published on May 22, 2009. It has been updated.

Fool contributor Richard Gibbons is looking to buy a swamp monster to put in his moat. He owns shares of Google and Microsoft and is short Google puts. Google is a Motley Fool Inside Value pick. Google is a Rule Breakersrecommendation. Charles Schwab is a Stock Advisor selection. The Fool owns shares of Google and Oracle. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.


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