I recently wrote how thinking like a business owner can help you identify excellent stocks. If you think like an owner, and focus less on fluctuating stock prices and more on analyzing companies' profits and competitive positions, you'll be better at identifying successful businesses.
But, in investing, achieving profits is only half the game. The other half is minimizing losses, and thinking like a business owner can help you avoid poor stocks, too.
Think like an owner
If you were an owner, what sort of business would you find really challenging to run? A capital-intensive cyclical business would be hard. If you have huge up-front costs for equipment, you run the risk of overestimating demand and failing to recoup your investment if the market slows.
It would be worse if the business sold a commodity with high levels of competition. If you can't differentiate your product from your competitors, then you'll have little pricing power. When you raise prices, your customers will just buy elsewhere.
It would be even more difficult if your high-fixed-cost business has low marginal costs. If simply opening the doors is expensive, but each customer costs almost nothing, then you have strong motivation to compete on price. After all, revenue from any new customer will flow directly to your bottom line, so you may as well give a bit on price to get the business.
But if your competition has similar motivations, then price wars could obliterate any profits.
Hard businesses
So what sorts of businesses have these sorts of characteristics? Airlines almost exactly match this business model. Continental Airlines (NYSE: CAL) went bankrupt twice in the 1980s, and both UAL's (Nasdaq: UAUA) United Air Lines and Delta Airlines filed for bankruptcy after 9/11. In fact, AMR (NYSE: AMR) is noteworthy because it hasn't gone bankrupt.
Airline travel is cyclical and commoditized. As a consumer, do you really care which airline you fly? Airlines have high fixed costs. Even if Siesta Airlines decides not to fly any planes today, it still has to pay leasing costs, maintenance, depreciation, and interest.
However, its marginal costs are low. It's no more expensive to fly a full plane than it is to fly a half-full plane. Siesta has motivation to cut its prices to get its planes as full as possible, since every extra passenger adds few extra costs.
Hotels are in a similar situation. In many respects, hotel rooms are commodities. The amenities offered by a Hilton (NYSE: HLT) are comparable to those offered by a Marriott (NYSE: MAR). Once again, there are high fixed costs like leasing, maintenance, and depreciation. But the marginal expenses of filling an extra room are low. Thus, there's motivation to compete on price.
The Foolish bottom line
Now, that's not to say that you can't make money in these stocks. Southwest Airlines (NYSE: LUV) had a great run in the 1990s offering great service at low prices. Four Seasons Hotels (NYSE: FS) distinguishes itself with the highest levels of service. And investors made excellent money buying Marriott in the post-9/11 dip.
You can make money in these stocks by focusing on the businesses that have truly differentiated themselves. Try to buy these stocks at extremely cheap prices to increase the upside and provide a margin of safety should things go wrong. Because in these industries, it often does.
Of course, unless you see a truly compelling opportunity, you can simply avoid these companies. There's no rule that you have to buy stocks in difficult industries when there are businesses with strong positions in better industries, trading at undervalued prices. If you're looking for some, we've identified many in our Inside Value newsletter. And you can see our top five picks for new money with a free trial.
Fool contributor Richard Gibbons doesn't have a vendetta against hotels and airlines any more. He also does not have a position in any of the stocks discussed in this article. The Motley Fool has a semi-tropical disclosure policy.
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