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 has 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 hit a depression. The real risk is buying a company whose competitive position is weakening, or weaker than it appears.

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 because of market share can be far weaker than it appears.

Take Charles Schwab. It has a good brand name and billions in assets under management, but its revenue last year was below its 2000 level. Unfortunately for Schwab, there are few barriers to creating an online brokerage. Interactive Brokers and thinkorswim have both made big splashes in the past few years by offering superior trading technology, while E*TRADE has also grown its brokerage top line significantly. Meanwhile, retail banks like Wells Fargo (NYSE: WFC  ) and Bank of America (NYSE: BAC  ) have begun offering online brokerage services.

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
The impact of fewer people reading newspapers has been obvious for years as advertising dollars have fled from papers to the Internet. But societal changes are affecting television networks as well. CBS has had declining revenue for years, while if you exclude the effects of the Olympics and acquisitions, General Electric's 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 it much easier for consumers 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 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 movie rentals can be affected.

For years, Blockbuster (NYSE: BBI  ) was the go-to movie rental chain. However, the advent of the Internet allowed Netflix (Nasdaq: NFLX  ) to offer movie rentals by mail or download. Netflix has grown its top-line 26% over the past five years -- and its bottom line even faster as it scales up -- stealing Blockbuster customers. Blockbuster became steadily less relevant and was finally filed for bankruptcy last month.

It's unlikely that the successor company will achieve the same dominance as it enters a new online arena to take on Netflix's first-mover position. Meanwhile, it still has to compete against other delivery mediums like DirecTV's (Nasdaq: DTV  ) pay-per-view service, which has enjoyed strong growth, and video retailers like Wal-Mart (NYSE: WMT  ) . So, when looking at beaten-down stocks, be particularly aware of technological threats to the business.

The Foolish bottom line
That said, this doesn't mean that you should never buy any company whose moat has weakened. Even from an eroding competitive position, some blue chips can generate cash for decades. But make sure that the price you pay is cheap even considering the impoverished prospects of the business.

Our Motley Fool Million Dollar Portfolio team spends a lot of time thinking about moats, and we've identified many excellent stocks that look exceptionally cheap today. If you'd like to learn more about Million Dollar Portfolio, click here.

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

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, 


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