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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 in 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 creating an online brokerage. Interactive Brokers and thinkorswim have both made big splashes in the last 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 a partnership between Morgan Stanley and Citigroup's (NYSE: C  ) Smith Barney 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), such as those offered by TiVo (Nasdaq: TIVO  ) , 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 storage 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. Blockbuster recognizes the risk and isn't just sitting back. It now offers video downloads. But, it's unlikely that the company will achieve the same dominance as it enters a new 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 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.

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 is long January 2011 $17.50 calls on Wells Fargo, and short May $20.00 calls. Netflix and Charles Schwab are Stock Advisor recommendations. Wal-Mart is an Inside Value selection. The Fool's disclosure policy wants to be an Alt-A mortgage when it grows up.

Read/Post Comments (2) | Recommend This Article (25)

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 August 30, 2009, at 10:37 AM, DEALWITHTHEDAY wrote:

    The hard part is pulling out my crystal ball and looking into the future. In 1980's is started with a 286 PC that did not have windows it was not around. I eventually went to Microsoft Dos following the rest of the world. My processor was so slow that it took what seemed hours to load. Now I have a Quad processor and do not wait for much. I has been about 25 years. Looking back I can see how this all came about. But in the 80's I could not decide which operating system to use. Was Microsoft Dos the best operating system at the time (In my opinion) no. But the trend and fad took it to the top.

    I made this long statement (and I am sorry for it) to set up a point. One item builds on another PC, Dos, etc.

    After a recession depression it seems new items allows come to the top of the trend.

    The true Money on Tech was not mad until the 1990's.

    If my short past is an indicator I would not see a trend coming out of this downtrend for a couple of years. I will be looking for that.

    I am not good enough to be able to pick it up early but I do appreciate articles like these as they keep me thinking and looking. Thanks.

  • Report this Comment On August 31, 2009, at 1:04 AM, exseries7 wrote:

    Agree with you about Schwab's long-term outlook and lack of moat. I have a Wells Fargo account that wants me to use their brokerage service with the enticement of numerous free trades to join. I cannot because although a US citizen, I reside abroad.

    So I use Schwab's International One account. My reward? I have to keep a minimum deposit of 25X that of domestic users. To add insult to injury, Schwab included new research in its redesigned website and promised all investors access. Then they discovered that international account holders like me are denied access to Credit Suisse research.

    That’s unfortunately what happens when a company gets too successful and becomes complacent.

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