7 Stocks That Could Cause Permanent Losses

In a recent research note to clients, former Societe Generale investment strategist James Montier identified 42 stocks worldwide that he believes threaten investors with a permanent loss of capital.

So what?
Montier is not your run-of-the mill investment strategist, which is one of the reasons I follow him. For instance, he once published a research note on the psychology of happiness with 10 suggestions, including the following: "Have sex (preferably with someone you love)."

Don't be fooled by this unorthodox style, though. Montier is no charlatan -- he's an expert on behavioral finance, and his work is steeped in the no-nonsense principles of value investing, as laid out by legendary teacher-investor Ben Graham.

In other words, it's worth your time and money to listen to what he has to say -- particularly on a matter as serious as preserving your wealth.

Permanent loss of capital vs. stock price drop
First, let me emphasize what value investors refer to by a permanent loss of capital. Whether stock losses are permanent can be determined only if you have a notion of the stock's intrinsic value. Two sets of circumstances can result in permanent loss: Either your cost basis was materially higher than the intrinsic value, or the intrinsic value itself has declined.

It's vital to understand that a drop in stock price does not cause a permanent loss of capital. Rather, if there is a mismatch between price and intrinsic value, there will be a downward adjustment in the stock price -- don't confuse cause and effect. Furthermore, not all stock-price drops are the product of latent permanent losses -- they may have other causes, such as forced selling and investor irrationality.

The trinity of risks
Now that we know what it is we are trying to avoid, let's focus on the three factors Montier refers to as the "trinity of risks" that can produce such losses:

1. Valuation risk: If earnings are at a cyclical high, the current P/E may be masking an overvalued stock. Montier uses an adjusted P/E ratio that replaces current earnings per share (EPS) in the denominator with a 10-year average EPS. This approach smoothes out the effect of earnings volatility and comes straight from the Ben Graham playbook. When screening for danger, Montier looks for stocks that have an adjusted P/E ratio greater than 16.

2. Balance sheet / financial risk: Excessive leverage can force a company into bankruptcy, no matter how sound the underlying business. Investors need to be particularly sensitive to financial risk in an environment that combines a sluggish economy and tight credit.

The Z-Score is a statistical indicator of bankruptcy risk developed by Edward Altman of NYU. Montier's screen identifies companies with a Z-score below 1.8, the "distressed" range which indicates companies run a significant risk of bankruptcy.

3. Business / earnings risk: If current earnings are significantly higher than their recent historical average, investors might be extrapolating future earnings from an inflated base and award the stock a valuation it doesn't deserve. This risk is exacerbated at the tail of a bubble. Montier looks for companies with current earnings per share that are double or more the 10-year average.

Using Montier's three criteria, I ran a screen and came up with 25 mid- and large-cap stocks trading on major U.S. exchanges. The following table contains seven of them:

Stock

Adjusted Price / Earnings Ratio*
(Oct. 30, 2009)

Z-Score

Latest Annual EPS/10-Year Average EPS*

Covanta Holding
(NYSE: CVA  )

206.0

1.19

10.8

IntercontinentalExchange
(NYSE: ICE  )

93.5

0.42

3.9

Brocade Communications
(Nasdaq: BRCD  )

80.1

1.68

4.0

Spectra Energy
(NYSE: SE  )

29.5

0.86

2.8

Tyco Electronics
(NYSE: TEL  )

29.3

1.56

5.1

CSX Corp

26.4

1.70

2.1

Norfolk Southern

21.4

1.72

2.1

*Note that, in certain cases, the average earnings may be calculated over fewer than 10 years for lack of data. Source: Capital IQ, a division of Standard & Poor's, as of Oct. 30, 2009.

A couple of surprise guests
I'm surprised to find two railroads show up on the list (CSX and Norfolk Southern), as this is a sector that super-investor Warren Buffett finds attractive. So much so, that his company, Berkshire Hathaway, announced this morning that it plans to acquire the 77.4 % of Burlington Northern (NYSE: BNI  ) it doesn't already own for $34 billion -- the largest deal in its history. Berkshire also owns shares of Norfolk Southern and Union Pacific.

Perhaps Buffett is mistaken ... or perhaps this simply illustrates that mechanical screens are inherently limited when it comes to analyzing single companies. Another example of this is that the screen is biased against legitimate high-growth companies, as the adjusted P/E and the ratio of current earnings to the 10-year average don't allow you to distinguish between secular increases (or declines) in earnings and cyclicality.

It's plain to see that for a company such as Akamai Technologies (Nasdaq: AKAM  ) , which has grown diluted earnings per share at an annualized rate of 86% over the last five years, both criteria could easily produce a false positive.

Safety first
All the same, the results should give investors pause. Cyclical or not, if you own any of the stocks in the table, it may be worth revisiting your analysis in light of these results.

James Montier's methodology is an excellent illustration of the way value investors think about avoiding permanent losses. The team at Motley Fool Inside Value follows the same principles to help their members sidestep sinkholes and invest in well-run, well-capitalized businesses trading at cheap prices. If that approach makes sense to you and you'd like to find out their five best recommendations for new money now, take advantage of a 30-day free trial today by clicking here.

Already a member of Inside Value? Log in at the top of this page.

This article was originally published on Feb. 12, 2009. It has been updated.

Fool contributor Alex Dumortier, CFA, has no beneficial interest in any of the companies mentioned in this article. Berkshire Hathaway is a Motley Fool Stock Advisor and an Inside Value choice. Spectra Energy is an Income Investor recommendation. Akamai Technologies is a Motley Fool Rule Breakers pick. The Motley Fool owns shares of Berkshire Hathaway. The Motley Fool has a disclosure policy.


Read/Post Comments (7) | Recommend This Article (9)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 03, 2009, at 5:51 PM, alraytse wrote:

    Alex,

    excellent article regarding brcd! I wonder if you could share with me what you would think a fair value would be for this company at this time. I agree 100% with you with p/e ratio but to be honest I have the company valued at around $5 or max $6 a share. How can they justify this lofty price range is beyong me. Looking forward to your reply, sincerely

    Alraytse

  • Report this Comment On November 03, 2009, at 11:46 PM, UltraContrarian wrote:

    Your SE P/E numbers are seriously wrong. The problem appears to be that Spectra was just spun off a few years ago and doesn't have 10 years of earnings history.

  • Report this Comment On November 04, 2009, at 10:12 AM, brocadelion wrote:

    stop the lies about Brocade!

  • Report this Comment On November 04, 2009, at 10:21 AM, brocadelion wrote:

    I wonder if any one at the Motley Fool has any interest in shorting Brocade!...it gets old after a while...shorting stocks should be made illegal because it is a good reason for many people to inject lies about companies so that they can grab the stock cheap...Brocade is here to stay and guess what it is in talks right now with a big three tech. company for a buyout within few weeks and you better own the stock when that happens...40% instant return on your money will be realized...do not listen to distractions and do not allow the thieves of wall street influence your thinking...be smart and do not listen to all these lies from the Motley Fool and others alike...pay attention to solid news not opinions that bring you down the slippery road!!! Think!

  • Report this Comment On November 04, 2009, at 1:57 PM, TMFSpiffyPop wrote:

    brocadelion,

    Pick the stock in CAPS if you feel strongly about it. I don't see any Outperform call on it. Assuming you're right, you'll be able to show the world how right you were and how wrong all the bears were. Plus, picking the stock may helps its rating and visibility in the CAPS database.

    I see that you haven't gotten started with CAPS yet. Let me highly encourage you to take a look and stand and be counted!

    http://www.caps.fool.com (read more in the help section as needed)

    For Brocade (presently a 3-star stock):

    http://caps.fool.com/Ticker/BRCD.aspx

    Fool on,

    David Gardner

  • Report this Comment On November 11, 2009, at 5:14 PM, Netteligent09 wrote:

    BRCD is a dead junk, overvalue, speculative, and high risk. The worst has yet to come.

  • Report this Comment On December 09, 2009, at 8:19 PM, Fool wrote:

    It would be very hard for SE to lose money and not recover? 20,000 odd miles of pipe getting "tolls" - please!

    If you want dogs we can find dogs!!!!!!

    CoolSoupy

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