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 has 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 because of market share can be far weaker than it appears.

Take Motorola (NYSE: MOT  ) . It has a good brand name and $22 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, whose mobile devices segment enjoys superior margins. Meanwhile, Research In Motion (Nasdaq: RIMM  ) and Apple (Nasdaq: AAPL  ) 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 has 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 been able to move in on newspaper revenues through classifieds and direct-shopping alternatives. 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) 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 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 eBay. Apple, Amazon, and eBay are Stock Advisor recommendations. Intel and Nokia are Inside Value picks. Motley Fool Options recommends buying calls on Intel and diagonal calls on eBay. The Fool's disclosure policy wants to be an Alt-A mortgage when it grows up.

 


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  • Report this Comment On February 18, 2010, at 11:44 AM, resko12 wrote:

    First if you are trying to educate the investor why leading them to a website where they have to pay to open your box where your valuable suggestion are?

    Frankly I have been dooped out of thousands of dollars by these morons who claim to be the invincible experts on the stock market....and guess what majority of the investors are stupids like me who buy into this scam artists trying to move the market with their suggestions and lead people into even paying them for it. Yeh I believe in buying cheap and selling high....but after all isn't that how the rich get richer and the poor poorer. These clowns have learned how to get rich and manupulate a circus shoe the so called stock market like their co-horts in other entities news, shows, etc. this is how it goes ...let's make an advise now we that have got some people listening to us and make our pocket cash before we cash in on the salary ande the bonuses that are waiting for us so we can pay for our life style of the rich and the famous. If you realy care about the investors why just tell them for free instead of leading them to a website where they find out oh no wait a minute this will cost you some cash!!!????

    The Investor

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