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. 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  ) and US Bancorp (NYSE: USB  ) 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 increasing competition.

Monster Worldwide (NYSE: MWW  ) 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.org. 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, Yahoo!, 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 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 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 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 now becoming apparent 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. Charles Schwab, Disney, and Interactive Brokers Group are Motley Fool Stock Advisor selections. Google is a Rule Breakers pick. The Fool's disclosure policy wants to be an Alt-A mortgage when it grows up.


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