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 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 it appears.

Take Motorola (NYSE: MOT  ) . It has a good brand name and $28 billion in annual sales, but that figure has been declining since 2006 as its market share continues to drop. A major problem is that there are few barriers to entry to producing mobile phones. Motorola faces stiff competition from Nokia (NYSE: NOK  ) , whose mobile devices segment enjoys superior margins. Meanwhile, fresh names like Apple (Nasdaq: AAPL  ) and Research In Motion are gaining traction with their smartphones. If Motorola truly had a huge moat, these companies would have had a difficult time competing.

Contrast this with the computer chip industry, which, being far more commoditized, offers greater economies of scale. That’s what’s enabled Intel (Nasdaq: INTC  ) , whose research and development expenses nearly exceed Advanced Micro Devices (NYSE: AMD  ) sales, to maintain such high margins for decades.

Times change
The impact of fewer people reading newspapers has been obvious for years, as advertising dollars have fled from papers to the Internet. Meanwhile, Craigslist, Amazon.com (Nasdaq: AMZN  ) , and eBay (Nasdaq: EBAY  ) have constructed classifieds and direct-shopping alternatives. 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. As if that weren't enough, personal video recorders (PVRs) and file sharing networks have made 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 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 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. 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 and 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 30 days for free by clicking here.

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 eBay and owns calls on eBay. Apple, Amazon.com and eBay are Stock Advisor selections. eBay, Intel, and Nokia are Inside Value recommendations. The Fool's disclosure policy wants to be an Alt-A mortgage when it grows up.


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  • Report this Comment On July 24, 2009, at 3:48 PM, tce25 wrote:

    Hey Motley Fool Guys,

    I see you shorted amazon yesterday and sent out an article today slamming it...hope you made a lot of money. I will stay long on amazon and not try to influence the market and make gains on stocks. You should probably sell your puts today as you succeeded in significantly driving down the stock...

  • Report this Comment On July 24, 2009, at 7:26 PM, jbonefish wrote:

    If they had this mch influence I think other picks would be doing better. If you want to direct your anger at market manipulation watch Goldman Sachs and their conviction "your a sucker" lists. No one else has the influence to drive prices higher as they unload positions (or lower to accumulate)

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