Dangerous Stocks That Will Burn Investors

For years, 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 a fraction of 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 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 eTrade (Nasdaq: ETFC  ) has also grown its brokerage top line 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.

Monster Worldwide faces a similar challenge. For about a decade, it's been perhaps the most well-known online recruiting site. Yet, in the past seven years, the company hasn't been able to exceed the peak revenue that it achieved in 2001. The problem is that, while the brand is good, it's both easy and inexpensive to create an employment website. As a result, Monster faces competition ranging from small local sites to Wharton Professor Devin Pope noted back in 2007 that in the largest 40 population areas in the United States, craigslist already had at least twice as many job postings as Monster. That competition makes it hard to grow, let alone achieve extraordinary margins.

Times change
While Monster's competitive advantage was always weaker than it appeared, 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 (Nasdaq: GOOG  ) , Yahoo!, and Microsoft's (Nasdaq: MSFT  ) MSN. But societal changes are impacting 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 (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 impacted.

For decades, Iron Mountain 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 -- 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. But, it's unlikely that the company will achieve the same dominance as it enters a new arena populated by tough, experienced competitors like EMC (NYSE: EMC  ) and IBM (NYSE: IBM  ) .

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, 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.

If you are looking to take advantage of the market decline, our Inside Value team spends a lot of time thinking about moats, and we've identified many excellent stocks that look exceptionally cheap today. You can read about them for free by clicking here for a 30-day free trial.

Fool contributor Richard Gibbons is looking to buy a swamp monster to put in his moat. He owns shares of Google and Microsoft. Charles Schwab is a Stock Advisor selection. Google is a Rule Breakers pick. Microsoft is an Inside Value selection. The Fool's disclosure policy wants to be an Alt-A mortgage when it grows up.

Read/Post Comments (10) | Recommend This Article (55)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 22, 2009, at 6:33 PM, gifoolsa wrote:

    Schwab business model has changed and the competitors you are talking about have nothing to do with that business model... In 2000 sch charged us loads for trading today you pay flat $8.95 or so per trade of any size... Look at the margin and how that has changed from mid teen to over 40%... Any way, very different businesses, very different... I would look at new assets and new accounts as measurement of performance together with growth in margin and earning...

  • Report this Comment On May 22, 2009, at 7:59 PM, GeminiLeo wrote:

    To suggest that owning shares of Schwab is dangerous, is slanderous and ignorant.

    The first poster is correct, the business models are very different for Schwab Vs IB, TOS & E-Trade. I own shares in Schwab and have for years. They pay a dividend and as well paid a one time special dividend of $1.00 per share. To the best of my knowledge the other firms listed in the article referring to Schwab don't pay a dividend and never have. I invest in companies who've demonstrated success for the long haul, pay something back to their shareholders and aren't in need of TARP funding. IB & TOS are solid firms but before I buy shares in either of them I'd like to see longer term results and a return to their shareholders. Oh and, Schwab has over a trillion in assets under management. Doesn't sound dangerous to me.

  • Report this Comment On May 22, 2009, at 9:02 PM, mythshakr wrote:

    I would like echo the opinions that the Schwab model is different and intended as much for and supportive of long term investors as frequent traders. The other three, in my opinion, depend solely on frequent traders to maintain their moat. With the likely new regulations intended to curb the recent abuses, the volume of frequent trading is likely to stabilize or possibly decrease reducing their moat at least as much as Schwab's.

  • Report this Comment On May 23, 2009, at 8:03 AM, exseries7 wrote:

    Agree that Schwab has had a winning formula and I am mostly happy trading with them. Their customer service is excellent, but they have recently made some strange changes. They are trying to switch users to a new Schwab site that supposedly is much improved, but they forgot the axiom of “If it's not broken, don't fix it." One of the carrots on the stick is to offer additional research available only to users of the new Schwab site. One problem with that is that their highly-touted Credit Suisse research is unavailable to Schwab One International customer. Why would any company make such a change that would alienate their international account customers, who must maintain substantially higher minimum balances then domestic customers? Sound a bit like the "New Coke"?

  • Report this Comment On May 23, 2009, at 12:58 PM, OklaBoston wrote:

    The Man Upstairs, if he exists at all, probably does know, but can be maddeningly uncommunicative when it suits his mysterious purposes. Which probably is a major reason there are so many atheists in this world. I'm an agnostic myself, in case anyone cares.

  • Report this Comment On May 24, 2009, at 3:51 AM, ozzfan1317 wrote:

    Your Comment feels quite think even at its Current Price GE is still worth a look. When a Company turns a 5 Billion Profit in the quarter its probably safe to say the business model isnt broken.

  • Report this Comment On May 24, 2009, at 1:10 PM, tomd728 wrote:


    Just a suggestion pal, but you might want to post

    up that jive on another channel somewhere.

    You got it !!!!!!!! I don't give a rat's behind what you're

    musing about.


  • Report this Comment On May 24, 2009, at 11:36 PM, Fool wrote:

    First thank you Tom

    Second buy Ge now sell in 2012.

    Sorry if I'm off topic but I typed in ge and got this.

  • Report this Comment On May 25, 2009, at 10:41 PM, kellogg9 wrote:

    As embarassing as this is to say i was one of those investors...boy have i learned and come a long way but hurts


  • Report this Comment On May 30, 2009, at 1:09 PM, carlady1220 wrote:

    i think ge is really worth looking at!!!!!! wake up!!

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