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. 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 in creating an online brokerage. Interactive Brokers and thinkorswim have both made big splashes in the last few years by offering superior trading technology. Meanwhile, TD Ameritrade (Nasdaq: AMTD  ) has also grown its brokerage top line significantly and big banks with huge depositor bases like Bank of America (NYSE: BAC  ) have also gotten into the mix. 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 increased 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 craigslist. Wharton Professor Devin Pope noted back in 2007 that in the 40 largest 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, Yahoo! (Nasdaq: YHOO  ) , and 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 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 -- despite News Corp. (NYSE: NWS  ) , NBC, and Disney's (NYSE: DIS  ) bold attempt to control their own fates with their own video-viewing site, Hulu. As if that weren't enough, personal video recorders (PVRs) and file sharing networks have made it 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 (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 -- 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 that is of great interest to a host of tech companies. EMC, Hewlett-Packard (NYSE: HPQ), and Seagate Technology (Nasdaq: STX) also offer offsite data recovery services.

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 any more, 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 30 days for free by clicking here.

This article was first published 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. Charles Schwab is a Stock Advisor selection. Walt Disney is an Inside Value and a Stock Advisor recommendation. Google is a Rule Breakers pick. The Fool's disclosure policy wants to be an Alt-A mortgage when it grows up.


Read/Post Comments (8) | Recommend This Article (11)

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 June 23, 2009, at 6:00 PM, tomald wrote:

    Richard did not paint an accurate picture of Iron Mountain and their use of electronic record storage. Iron Mountain is not manufacturing electronic storage they are using the technology to remotely backup servers and PCs. so instead of people shipping their data overland they are capturing data electroically, and stroing it on their servers.They are not competing with the likes of HP and Seagate. Their product works very well and is simple to use.

  • Report this Comment On June 24, 2009, at 7:56 AM, jacksonstamp wrote:

    You're description of IRM's move into the digital world is way off. Like tomald said above, they aren't building hardware. Please explain how they compete with a company like Seagate? I've been following IRM for years now and that description above looks like you visited their website and made up the rest. Terrible article.

  • Report this Comment On June 24, 2009, at 9:53 AM, tomald wrote:

    How about an answer Richard - where did you get your information from - stop hiding

  • Report this Comment On June 24, 2009, at 8:29 PM, tomald wrote:

    I would recommend that The Fools drop you as a "fool contributor" because of this article. This article on IRM was so inept and infantile that you should be banned for doing this to a company. You have no creditabilty and if "the fool" continues to use your articles they will also lose their creditabilty.

  • Report this Comment On June 30, 2009, at 4:11 PM, TMFDiogenes wrote:

    Hey tomald and jacksonstamp,

    HPQ and STX appear to offer products that allow companies to perform their own electronic record management. If not direct competitors, they seem to offer substitutes. Does that jive with how you view these products? Here are a few sources:

    HPQ:

    http://h18006.www1.hp.com/products/software/im/governance_ed...

    http://h30261.www3.hp.com/phoenix.zhtml?c=71087&p=irol-n...

    STX:

    http://www.i365.com/ediscovery/

    Thanks for posting,

    Ilan

  • Report this Comment On June 30, 2009, at 5:26 PM, tomald wrote:

    Hi IIan,

    Basically Iron Mountain has been an offsite storage facility for many years. I worked at a bank back in the 70's and we had a courier drive our computer tapes/cartridges, and documents to their facility daily Mon - Fri, about a 4hr round trip. IM now offers electronic storage where you install software on your server/PC and it will copy data and store it on servers in their facility. You can also restore the data to your servers down to the document level very simply and quickly. This solves 3 problems for organizations - 1. you have backup, 2. it is stored offsite, and 3 it is done in a timely manner. You no longer have to send a courier to their facility. IM could possibly use the products that HP and STX manufacture. Companies can purchase the HP and STX products but it does not solve the offsite storage problem

  • Report this Comment On July 07, 2009, at 5:40 PM, jacksonstamp wrote:

    IRM is an information storage and management company. They are the largest company in their business by far. For each one of their services you can find competitors that offer a similar solution. What IRM does is very different. They want to store the data regardless of how you get it to them. They do offer point solutions to do this (LiveVault, DMS, Connected, Tape pickup, Medical imaging. document management systems, Email Archiving, eDiscovery) so they provide the means to move data both physically and digitally to their facilities. HP doesn't do that and neither does Seagate. They don't offer anything remotely similar. Fact is, nobody does.

    For future reference:

    http://www.ironmountain.com/services/

    My point of commenting in the first place was because your article popped up on my IRM screen. After reading it I came to the conclusion that zero research was done for this piece which makes me question the value of Fool.com. Why bother writing the piece on a company you know nothing about? Seems to me your readers would have been better served if you wrote the article about HP and Seagate's solutions and mentioned IRM as a competitor instead focusing on the latter...

  • Report this Comment On August 14, 2009, at 4:16 PM, rovingartisan wrote:

    I agree with jacksonstamp's assessment of this article's coverage of IRM. I am a new fool who worked in the software industry for many years.

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