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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 if we hit a depression. The real risk is buying a company whose competitive position is weakening, or weaker than it appears.

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 past few years by offering superior trading technology, while E*TRADE (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 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 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 affected.

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 (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 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 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 free by clicking here for a 30-day free trial.

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 owns shares of Google and Microsoft. Charles Schwab and Interactive Brokers Group are Motley Fool Stock Advisor selections. Google is a Rule Breakers pick. Microsoft is an Inside Value selection. Motley Fool Options recommended buying a diagonal call on Microsoft. The Fool's disclosure policy wants to be an Alt-A mortgage when it grows up.

Read/Post Comments (3) | Recommend This Article (13)

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 December 11, 2009, at 10:08 AM, stockguru2014 wrote:

    What a fool. 2000 was a bubble year for brokerages. Why not also compare ETFC's revenue and earnings, then compare them to Schwab's? Schwab has not only managed to maintain profitable earnings but they have grown margins because they have a solid management group running the company. Compare that to ETFC with it's continual revolving door at management and 2 straight years of losses. isn;t even funny. Schwab now has introduced low fee/commission free ETF's to the market. That is going to be huge for Schwab and will help propel earnings for years to come. Schwab is a bargain right now.

    Comparing any brokerage company revenue to 2000 is ridiculous and unfair since that was a bubble year. Why not compare their revenues to 1999, 1998, 1997, 1996, etc etc, Then the case could be made that Schwab is doing great.

  • Report this Comment On December 11, 2009, at 10:11 AM, stockguru2014 wrote:

    Waht a fool. 2000 was a bubble year. It is unfair to compare any company to a bubble year. Schwab has done a great job of maintaining profitability and there is no reason to think they cant in the future. The author said that ETFC has grown its brokerage busisness. Care to check out their 2000 revenues as a comparison? Doh

  • Report this Comment On December 12, 2009, at 5:42 PM, Fool wrote:

    I used to work for etrade at a very low wage and I'm seeing that etrade and many other companies focus too much on how to reward their vp's in stead of working on bettering the company. They seem to dream up ways to reward visionary etc. You see waht has happened over these past years..time to earn their money..i did.

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