6 Stocks With Plenty to Lose

I once heard Donald Trump explain to a news reporter, while pointing to gold faucets in one of his posh New York buildings, that his real estate strategy involves buying the best. Really? Most people who’ve built a house, picked a college or bought a laptop have performed more careful analysis than that. They’ve mentally looked for what an economist would call a break in the price/quality curve: The $800 laptop is much better than the $600 one, and only a little worse than the $1,500 one, so it’s the best for the money.

Trump can be forgiven a bit of empty posturing, since he may have more of a stake in his own celebrity than in real estate. (Dozens of buildings that bear his name do so under licensing agreements.) But stock pundits make the same mistake when they overstate the importance of buying industry leaders — the best-of-breed, if you like. These companies are defined by dominant market shares and plump profit margins. They’re adored on Wall Street. Those are dangerous traits for stockholders.

Large market shares are difficult to improve upon. Oversized profit margins tend to eventually revert to industry averages, as successful companies are mimicked by competitors. Premium valuations tend to shrink, too. Five years ago, few investors would have felt unsafe with choice stocks like Intel (INTC), Starbucks (SBUX) and Whole Foods (WFMI). But while the stock market has lost a quarter of its value since then, these three have lost more than half. (Intel, with plenty of cash and a fine dividend, is close to being a bargain by my math. Starbucks and Whole Foods aren’t.) Better to shop for stock bargains among middle-performers that look likely to improve, or else within young industries where everyone has room to grow.

Below I’ve listed terrific companies, but ones whose shares I would avoid for now, because their wide profit margins and lofty valuations suggest more to lose than to gain.

Over the past year, Dolby Laboratories (DLB) turned 45 cents of each sales dollar into operating profit, versus a nickel for the average electronics company. That’s because much of Dolby’s business involves collecting royalties for its technology, while leaving the manufacturing to others. Dolby gets paid for every DVD and Blu-ray player made world-wide, for every digital television in North America and for game consoles and portable music players. But that gives the company heavy exposure to a slowdown in consumer spending. Sales are seen growing at just 9% this year and earnings are expected to dip. Dolby has enough cash to weather a downturn, but shares are 50% more expensive than the broad market based on earnings. I’d be wary of paying that much even if Dolby paid a decent dividend. It pays none.

I recommended Marvel (MVL) stock at $16 in June 2003 and at $28 in April 2007, but thought it pricey last summer at $35. It’s $28 now, which looks like a good deal next to forecast 2008 profits of $2.58 a share. But last year’s results were powered by the films “Iron Man” and “The Incredible Hulk,” which combined for more than $800 million in world-wide ticket sales. This year Marvel isn’t expected to release any films of its own, so profits are forecast to tumble to $1.30 a share. Long-term holders, take heart: Marvel is financially strong, owns valuable properties, is plenty profitable and only just started making its own films. Eventually, it will time production schedules so as to have a couple of big releases each year. But in the meantime, shares fetch 22 times 2009 earnings and pay no dividend. Look for a price cut later in the year (and then consider buying).

Finally, Berkshire Hathaway (BRK.B) doesn’t have a market share or profit margin as such, because it’s an investment vehicle for Warren Buffett. Stay clear of it, not because Buffett’s skill is overstated (it’s not), but because his fans are too adoring. One sign: There’s a link for ordering “Berkshire Activewear” on the company’s home page. Shares carry a price that would probably eliminate them from one of Buffett’s own value screens; they’re a third more expensive than the broad market based on underlying earnings. To follow Buffett on the cheap, either read up on his methods and screen for your own stocks, or mimic his purchases directly. You can’t do that with companies he buys in full, of course, and you can’t match special terms he’s able to secure for things like preferred shares. But you can find Berkshire’s common stock holdings by looking through its securities filings. Also, CNBC keeps track of them in a nifty table on its web site.

Below are some other names to shun for now.