How to Make a Small Fortune

Editor's note: An earlier version of this article stated that AirTran Holdings had posted back-to-back quarterly losses. We regret the error.

There's an old joke about airlines that goes something like this:

Q: How do you make a small fortune in the airlines?

A: Start with a large fortune!

The general rule of thumb in any competitive business is that if there's profit to be made, someone with much deeper pockets is probably already trying to get in on the action. That's one reason Southwest is one of a few generally profitable standouts in the airline business, despite being known for its low prices. Its balance sheet, touting more cash than debt, is exceptionally strong for its industry, and the lack of a heavy debt anchor allows it to charge less than its competitors for essentially the same service. As a result, it thrives in an industry where players such as Hawaiian Holdings (AMEX:HA) routinely flirt with bankruptcy, and even the usually solid AirTran Holdings (NYSE:AAI) posted a quarterly loss earlier this year.

Not just an airline problem
The same rule of deep pockets chasing profits applies to just about any industry. Particularly vulnerable are companies that, like the airlines, suffer from an ugly combination of high capital costs and relatively light non-financial barriers to entry.

Take the company with this financial history:

This company's 2005 revenues were higher than its total costs of operating in 2002, or even 2000 and 2001 combined, yet its losses have simply gotten larger and larger. The ugly truth is that even with its rapid growth, it's unable to cover its costs. Even if it more than doubled in size in 2006, with no additional expenses (which is highly unlikely), it'd still lose money. In fact, with the first half of 2006 reported, the nasty financial trends look like they're continuing unabated.

Add to those outrageously escalating costs an ever-increasing debt and an exceptionally dilutive share count, and you have yourself a recipe for a financial disaster. Ignoring the company's name for a minute and just looking at the numbers, tell me: Is that the kind of business you would want to own? Me, neither. In fact, this type of ever-deeper money pit is exactly the type of company we avoid at Motley Fool Inside Value. Yet somebody thinks this particular company is worth more than $3 billion, since that's where recent stock trades value the business.

Pull back the curtain
So what exactly is this company? None other than digital satellite radio pioneer XM Satellite Radio. If you think differently of the business now than you did before I revealed its name, ask yourself why. Frankly, XM has more in common with the troubled legacy airlines than you'd probably expect. First, there's the large and ever-growing debt needed to support those expensive and fragile satellites. Then there's the company's ugly inability to turn a profit. Plus, let's not forget the sniping competition. Sure, there's archrival Sirius Satellite Radio. But while we're naming names, what about traditional AM/FM radio firms such as EntercomCommunications (NYSE:ETM) or multimodal news and entertainment giants such as Disney (NYSE:DIS)? And who could forget subscription services such as RealNetworks (NASDAQ:RNWK) and its library of on-demand music?

The ugly truth is, even if XM survives, it probably won't ever be amazingly profitable. There are just too many reasonable alternatives available at lower price points. For a closer parallel than the airlines, look no further than radio's kissing cousin -- television. Remember the now-defunct Voom satellite television service? How about now-bankrupt Adelphia cable? Even the surviving players' businesses have not thrived. Take a look at this chart comparing cable TV firm Charter Communications (NASDAQ:CHTR) and British television giant British Sky Broadcasting Group (NYSE:BSY) with the market over the past five years. Their less-than-stellar business performance is fully reflected in their below-market returns to investors.

Follow the money
If you're serious about making money with your investments, you need to ignore the hype, hysteria, and hoopla. Focus on the cash the business generates, what the risks are to that cash, and what the company is doing to protect its wealth-generating operations. Over time, a business is valued based on nothing more than its ability to create cash for its owners. Avoid the companies that constantly drain cash and stick with the ones that throw it off in abundance, and you'll do just fine.

Even better, if you buy those cash-generators on sale while the market is focused on the next big thing, you will earn an excess profit, thanks to your discounted purchase price. That is exactly what we do at Inside Value: We look for companies that are making money hand-over-fist, yet trading at closeout-rack prices. When we find those stocks, we pick them. Then we simply wait for the market to realize its mistake and bid those firms back up to their true value. It's an amazingly straightforward strategy that has withstood the test of time.

If this sounds like an investing strategy that would work for you, then you're in luck. Simply click here for a 30-day, no-obligation, free trial. You'll have access to the latest issue of Inside Value, which has two value-priced stock recommendations, as well as our members-only tools, special reports, and back issues.

If you're tired of being burned by investments that have overpromised and underdelivered, and you're ready to stop throwing good money after bad, Inside Value is for you.

This article was originally published on March 6, 2006. It has been updated.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta had no ownership stake in any of the companies mentioned in this article. XM Satellite Radio is a Rule Breakers recommendation. Entercom is an Income Investor pick. Disney is a Stock Advisor pick. The Motley Fool has adisclosure policy.