How To Make a Small Fortune

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: If there's a profit to be made, someone with much deeper pockets is probably already trying to get in on the action. That's one reason Southwest Airlines 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 and short-term investments than long-term debt, is exceptionally strong for its industry. The lack of a heavy debt anchor allows it to charge less than its competitors for essentially the same service. As a result, it has thrived in an industry where players such as Delta (NYSE:DAL) regularly flirt with bankruptcy and surviving firms like Alaska Air (NYSE:ALK) struggle with the impact of those bankruptcies on their own businesses.

Not just an airline problem
The same rule of deep pockets chasing profits applies to just about any industry. The most vulnerable companies, much 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 2006 revenues were higher than its total costs in 2003, or even 2001 and 2002 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. It would essentially need to double in size in 2007, with no additional expenses, in order to avoid losing money. That's highly unlikely. For instance, despite hauling in $375 million more in revenue in 2006 than in 2005, its losses still managed to worsen by more than $55 million.

Add to those outrageously escalating costs an increasing debt load and an exceptionally dilutive share count, and you have yourself a recipe for 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-deepening money pit is exactly the type of company we avoid at Motley Fool Inside Value. Still, somebody thinks this particular company is worth $3.2 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 its 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-turned-prospective mate Sirius Satellite Radio. But while we're naming names, what about traditional AM/FM radio firms like Cumulus Media (NASDAQ:CMLS) and Corus Entertainment (NYSE:CJR)? Even technology titan Microsoft (NASDAQ:MSFT) is trying to muscle into the digital music fray with its Zune.

The sad 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? Take a look at this chart comparing TV broadcasters Sinclair (NASDAQ:SBGI) and Entravision Communications (NYSE:EVC) with the market over the past four 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, the risks 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'll earn an excess profit from your discounted purchase price. That's 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 investing strategy sounds like it would work for you, 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.

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 owned shares of Microsoft, which is an Inside Value recommendation. The Motley Fool has a disclosure policy.