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.

After all, these days, you can buy many of the best companies in the world for less than 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 lies in 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 Charles Schwab. It has a good brand name and billions in assets under management, but its revenue last year was below its 2000 level. 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 past few years by offering superior trading technology, while E*TRADE has also grown its brokerage top line significantly. Meanwhile, retail banks such as 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, which they have. 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, given increasing competition from depository banks that can leverage existing clients into brokerage services.

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, and if you exclude the effects of the Olympics and acquisitions, General Electric's NBC unit has also 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. It doesn't particularly matter to the value of their weakening moats that TiVo is expected to continue losing money for a few years; 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 movie rentals 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. While Blockbuster's sales are in sharp decline, Netflix's are booming. 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. It trails other runners-up like Wal-Mart (NYSE: WMT  ) and Best Buy (NYSE: BBY  ) in online video delivery -- both of which are determined to sell videos online and have very deep pockets.

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 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 companies mentioned. Best Buy and Charles Schwab are Stock Advisor recommendations. Best Buy, Netflix, and Wal-Mart are Inside Value selections. The Fool owns shares of Best Buy. The Fool's disclosure policy wants to be an Alt-A mortgage when it grows up.

Read/Post Comments (6) | Recommend This Article (13)

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  • Report this Comment On April 29, 2010, at 4:19 PM, madmilker wrote:

    Now, lets see, Wal*Mart closed at $69.12 at the end of December 1999. Lee took over the first of 2000 and way the end of his first month the share price was down to less than $55.

    But this is the kicker after all most 11 years...

    when you figure inflation....the share price would have to be over $88 today...just to be at even money.

    oh! I forgot...they paying a whooping 2% dividend but for the past 5 years....they selling $2 billion a year in Bonds and they still $41 billion in debt.


    does Warren always put his left shoe on first?

    on Wal*Mart's China web page!

    "Wal-Mart China persists in local procurement which provides more job opportunities, supports local manufacture industry and promotes local economy. So far, 95% of merchandising sold at Wal-Mart China store are local products by which Wal-Mart has established business relations with nearly 20,000 suppliers. At Wal-Mart, we treat suppliers as partners and would like to develop with them. In 2008 Wal-Mart won the Supplier Satisfaction published by Business Information of Shanghai for five consecutive years."

    that doesn't support American export and American jobs....

    think about George....

    Remember what Lance Winslow wrote in that article "The Flow of Trade in a Global Economy"....dang! better yet...jus take the time and read this ...."Now let us look at Wal-Mart again; you buy a product there, 6% goes to the employees, 10-18% is profit to the company, 25% goes to other costs and 50% goes to re-stock or the cost of goods sold. Of the 50% about 20-25% goes to China, a guess, but you get the point. Now then, how long will it take at 433 Billion dollars at year for China to have all of our money, leaving no money flow for us to circulate? At a 17 Trillion dollar economy less than 40-years minus the 1/6 they buy from us. Some say that if we keep putting money into our economy, it would take forever, but if we do not then eventually all the money flow will go. If China buys our debt then eventually they own us, no need to worry about a war, they are buying America, due in part to our own mismanaged trade, so whose fault is that? Not necessarily China, as they are doing what's in the best interests, and we should make sure that trade is not only free, but fair too."

    Also, think for a moment about George Washington....yes the man that is on the US dollar bill.... "Washington had been reelected unanimously in 1792. His decision not to seek a third term established a tradition that is now embedded in the 22d Amendment of the Constitution."

    Take the time to read his farewell address after only eight years of serving his country and than ask yourself this....How do you think George feels being sent overseas in return for all that foreign so-call cheap items and being left in a foreign bank because the American worker doesn't make anything for the foreigners to buy. Cheap items didn't make this great union of 57...oops! 50 states the greatest place on the face of this Earth.....the American worker (union and non-union) did.

    You can't have a strong country without having a strong currency and you can't have a strong currency unless you keep it floating around within your 50 states. This is why the store with the star in the name puts 95% China made items in their stores in keep their "yuan" in their country helping the nice people there. And with only 5% left for all the other 182 country's that make stuff including the United States of America....that doesn't produce very many jobs outside of China.

    Being an old person myself and knowing how it was back in the 40's, 50's and 60's in this union of 50 states....I look at George each time I pull him out of my billfold and make a promise to send him out for items made in America so after floating around helping each hand he touches just maybe one day he will shake mine again.

  • Report this Comment On April 29, 2010, at 4:21 PM, madmilker wrote:

    Retail makes nothing...

    Invest in something....

    Made In America...

  • Report this Comment On April 29, 2010, at 4:22 PM, madmilker wrote:

    I have told all the turnips on Jenkin's Hill in Washington D. C. about those 15 cargo ships that pollute as much as 760 million automobiles...


  • Report this Comment On April 29, 2010, at 4:27 PM, madmilker wrote:

    Will the Messiah pay for the fishing trip this year.

    "”Considering that there are over 30,000 ships at sea this morning,” writes James Carlton, director of the Williams College-Mystic Seaport Maritime Studies Program, in an e-mail, “the total number of organisms and species in this global ‘bioflow’ on the morning your readers read your piece could be staggering – billions of individuals, and thousands of species.”

    Indeed, scientists have long considered ballast water the primary way invasive aquatic organisms are introduced. From the zebra mussel’s arrival in the Great Lakes, to an American jellyfish severely disrupting Black Sea fisheries, the potential costs of accidental introduction of a species to new homes can be tremendous. Aquatic invasives cost the US $9 billion yearly, according to estimates by David Pimentel, professor emeritus of ecology and evolutionary biology at Cornell University in Ithaca, N.Y. Zebra and quagga mussels (a cousin to the zebra) alone cost the $1 billion annually."

    $9 billion a year to clean fish from ballast tanks of ships and the bill is always sent to the American taxpayers....

    Don't know about you....but they can shove all those so-call cheap items inside those ballast tanks with the dang fish and send them back to Asia.

  • Report this Comment On April 29, 2010, at 6:47 PM, leadreviewer wrote:

    Blockbuster now offers the same internet deal Ntflx offers & also the same deal Rdbx offers, but much better because of the new releases they only have.. Watch how thing will change!

  • Report this Comment On April 29, 2010, at 7:42 PM, artbcpa wrote:

    Why in the world would anyone stop doing business with one of the best run companies in the US - Netflix? They provide superior service. They care about their customers. They provided a superior product before companies like Blockbuster were forced to make changes to compete. I'm sticking with Netflix - their product and their stock. Well run companies are rewarded in the marketplace.

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