7 Stocks That Could Cause Permanent Losses

In a note to clients last year, 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's define "permanent loss of capital" -- a concept that hinges on a given stock's intrinsic value. If the price you paid for the stock was materially higher than its actual worth, or the intrinsic value itself has declined, you've suffered a permanent loss.

It's vital to understand that a drop in stock price does not cause a permanent loss. If a stock's price doesn't match its intrinsic value, the market will eventually adjust that price until it does. Don't confuse cause and effect. Furthermore, such a mismatch doesn't cause every stock-price drop; forced selling, investor irrationality, and other culprits can also drive shares lower.

The trinity of risks
Now that we know what we're 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 might mask an overvalued stock. Montier uses an adjusted P/E ratio that replaces current earnings per share (EPS) 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: Too much debt or other leverage can force a company into bankruptcy, no matter how sound its underlying business. When the economy's sluggish and credit is tight, investors must be particularly sensitive to financial risk.

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 that companies run a significant risk of bankruptcy.

3. Business/earnings risk: If current earnings significantly exceed their recent historical average, investors might be apply that inflated number to project exaggerated future earnings, giving the stock a value it doesn't deserve. The tail of a bubble can make this risk worse. Montier looks for companies with current earnings-per-share (EPS) that are double or more the 10-year average.

Using Montier's three criteria, I ran a screen that yielded 25 stocks trading on major U.S. exchanges with a market value greater than $500 million. The following table contains seven of them:

*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 May 6, 2010.

A surprise guest
I was surprised to find exchange operators on the list (IntercontinentalExchange), since I find that sector attractive. Either I'm mistaken, or mechanical screens are inherently limited when it comes to analyzing individual companies. For example, Montier's screen is biased against legitimate high-growth companies; the adjusted P/E and the ratio of current earnings to the 10-year average don't distinguish between the simple ups and downs of economic cycles, and well-deserved increases (or decreases in a company's earnings.

For companies such as Newmont Mining (NYSE: NEM) and eBay (Nasdaq: EBAY), which have produced respective 10-year annualized EPS growth of 40% and 73% both criteria can easily produce a false positive:

*As of May 6, 2010. Source: Capital IQ, a division of Standard & Poor's.

Safety first
That said, 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 9 Best Buy Now stocks, take advantage of a 30-day free trial today by clicking here.

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

Fool contributor Alex Dumortier has no beneficial interest in any of the companies mentioned in this article. eBay is a Motley Fool Stock Advisor pick. Motley Fool Options has recommended a bull call spread position on eBay. TransDigm is a Motley Fool Hidden Gemsselection. The Motley Fool has a disclosure policy.