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. That strategy has made him billions, and it's perfectly suited to today's market. 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 lies in buying a company whose competitive position is weaker than it appears, or just getting weaker.

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 less than it generated 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 and a partnership between Morgan Stanley and Citigroup's 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 social changes are affecting television networks as well. CBS has had declining revenue for years, and 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 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.

Garmin (Nasdaq: GRMN  ) is one of the go-to brands for personal navigation devices. However, the rise of smartphones with GPS capabilities and Google Maps reduces the need for consumers to buy separate navigation devices.

Garmin recognizes the risk and isn't just sitting back. It's selling GPS devices directly to OEMs like Honda (NYSE: HMC  ) , Harley-Davidson (NYSE: HOG  ) , Toyota (NYSE: TM  ) and launching its own smartphone.

But as basically a commodity supplier, it's unlikely that the company will achieve the same margins in the OEM space as it did selling personal navigation devices. Moreover, Garmin is at a competitive disadvantage in the smartphone market; it will have to compete head-to-head with tough, experienced competitors with stronger brands, like Apple, Nokia, and Research In Motion (Nasdaq: RIMM  ) on their home turf.

Moveover, in choosing to go with AT&T, rather than Verizon (NYSE: VZ  ) or Sprint (NYSE: S  ) , Garmin basically guaranteed itself second-fiddle status to the AT&T's/iPhone partnership.

So when looking at beaten-down stocks, be particularly aware of technological threats to the business.

The Foolish bottom line
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. Just 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 Motley Fool 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.

Already subscribe to Inside Value? Log in at the top of this page.

This article was originally 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 doesn't own shares of any company mentioned. Garmin is a Motley Fool Global Gains recommendation. Sprint and Nokia are Inside Value picks. Apple, Interactive Brokers, and Charles Schwab are Stock Advisor selections. The Fool's disclosure policy wants to be an Alt-A mortgage when it grows up.


Read/Post Comments (0) | Recommend This Article (10)

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.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 997742, ~/Articles/ArticleHandler.aspx, 8/21/2014 8:12:53 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement