Avoiding Permanent Losses of Capital

It's a dreadful time for the stock market. Fear has struck Wall Street; investors are panicking about the future of our economy, causing stock prices to plunge. But how do you differentiate between general fluctuations in the market and permanent losses of capital?

Permanent capital loss: a definition
To me, a permanent loss of capital is a stock that goes down because of deteriorating business operations, and it stays down for a very long time or even forever. For example, if a company goes bankrupt, or its earnings power becomes permanently impaired, shareholder value will also become permanently impaired. That said, here are some conditions you need to know about to avoid these dreaded losses.

Avoid leverage
Leverage magnifies gains and losses, and can make temporary setbacks permanent. Over the past couple of years, homeowners borrowed a lot of money that they couldn't afford to bet on rising home prices.

Of course, in the long term, home prices will rise again. But now prices are tumbling, and the surplus of inventory and lack of credit has left investors without any buyers for the real estate they purchased. Consequently, investors who leveraged their purchases too heavily will be forced to declare bankruptcy. Thus, this temporary downturn in the housing industry has become a permanent loss for many investors.

Countrywide Financial (NYSE: CFC  ) is a textbook case in which shareholders suffered a permanent loss of capital in large part due to excessive leverage. Founded in 1969, the company was renowned for its history of surviving brutal real estate and mortgage cycles and became the largest mortgage lender in the U.S.

However, Countrywide's nearly four decades of successfully navigating those cycles stopped dead in the water when excessive use of debt left it with an evaporating margin of error. Using a simple measure of leverage (assets divided by equity), the numbers (in billions) tell the tale:

1993

1997

2002

2006

Assets

3,299.1

7,689

58,030.7

199,946.2

Equity

693.1

1,611.5

5,161.1

14,317.8

Assets/Equity

4.8

4.8

11.2

14.0

Many factors contributed to Countrywide's downfall, but excessive leverage clearly played one of the largest roles in forcing Countrywide to sell itself at a low price to the more financially stable Income Investor pick Bank of America (NYSE: BAC  ) .

Avoid obsolescence
As new technology rolls in, outmoded ideas fade. The rise of the Internet made big winners out of search engines like Google (Nasdaq: GOOG  ) and Stock Advisor recommendation Yahoo! (Nasdaq: YHOO  ) . But as this new method of obtaining data rapidly spread, Internet users abandoned newspapers. The loss of traditional newspaper readers might be permanent, and that has severely impaired the industry's earning power.

Shareholders who didn't anticipate the newspaper's gradual obsolescence and bought shares of The New York Times (NYSE: NYT  ) around $50 per share back in 2004 have probably suffered a permanent impairment of capital. Shares now languish around $15 per share.

Understanding where a company is in the life cycle of its industry is crucial for an investor. Companies that lose competitiveness to new technologies might never recover, and that dissolution will result in a permanent loss for investors who arrive too late to the party.

Avoid shrinking moats
In addition to leveraging and obsolescence, a shrinking moat can also permanently impair shareholder value. Warren Buffett, chairman of Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) , purchased Dexter Shoe, a U.S. shoe manufacturer, in 1993. However, the shoe industry was in the process of being outsourced to Asia, where manufacturers using cheap labor could severely undercut domestic producers.

So even the best investors make mistakes, and Buffett later noted that purchasing Dexter was clearly a mistake on his part, due to its dwindling competitive advantages.

Prices are down, but not all stocks are bargains
Investors are sitting on some fairly large losses so far this year. True, many stocks are down because of overall market volatility, and prices will eventually reverse as our economy strengthens over time. However, some stocks may be down for more reasons than just general market movement.

It's important for investors to distinguish how companies stand relative to these conditions, and whether the ones that are selling now are a true value and have the potential to rebound.

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