The 10 Worst Recession Stocks

Last month, I published my updated list of the 10 best-performing stocks since the last recession, to help you identify the lessons that will help us this time around.

The study yielded some fascinating insights, not least of which was that investors who keep their wits about them during times of maximum pessimism can truly make money on incredible stocks.

When my colleague John Reeves and I first began this study a year ago, we got some great email feedback from our Foolish readers, some of whom suggested that a piece on the 10 worst stocks since the last recession would also be helpful. And we knew taking that route would be fun.

To keep things interesting, I excluded bankruptcies and de-listed stocks. Without further ado:

Data from Capital IQ, a division of Standard & Poor's. Includes domestic and Canadian stocks traded over major exchanges and capitalized above $200 million as of Dec. 31, 2000. Note: Past performance does not necessarily indicate future performance.
*For the year 2000.
**Excludes the possible outlier, Cell Therapeutics.

Before I can share with you what accounts for these ugly returns -- and what you should avoid today -- a word about what wasn't responsible for their underperformance.

Stock price histories
While some of the worst recession stocks declined substantially during the actual recession (March to November 2001), others appreciated. This shows that beaten-down stocks can be great opportunities, but only if the company itself isn't doomed.

Some of the most startling cases include MBIA (NYSE:MBI) and PotashCorp (NYSE:POT), both of which remained flat during the recession but have since dropped by 92% and risen by 461%, respectively.

That's why, back in September, I warned investors not to touch value traps Citigroup, Lehman, and Wachovia. Those stocks appeared tempting to many investors, even though their businesses had deteriorated alongside their share prices.

Simply put, past price histories cannot tell you whether a company is undervalued or overvalued today.

With that out of the way, here are four things you should avoid:

1. No profits
What counts as "very profitable" varies by industry, but you generally want to see companies with a return on equity of at least 10%. Every one of the 10 worst recession stocks lost money in 2000.

2. Too much debt
Several of the worst stocks had onerous debt loads. Too much debt limits a company's ability to take risks and increases the chances of a blowup should the business hit a rough patch. The worst stocks didn't have a buffer between their operating incomes and interest payments and, in most cases, actually had negative operating income. (In fact, seven of the 10 worst recession stocks had no operating earnings with which to pay the interest on their debt!) This feature has held particularly true during the current credit crisis, as highly leveraged firms like Washington Mutual, Bank of America (NYSE:BAC), and Lehman Brothers were some of the hardest hit.

3. Overpaid CEOs
When I showed this list of worst stocks to Fool co-founder Tom Gardner, he immediately brought up the issue of executive compensation. At the Fool, we've always noted that excessive compensation can indicate that the folks in management lack internal motivation and may induce them to maximize short-term performance at the expense of their company's long-term health.

To take a recent example, Lehman Brothers CEO Dick Fuld -- whose salary, bonuses, and options from 2000 to 2007 came out to more than $14,000 per hour (even assuming 80-hour work weeks!) -- oversaw the destruction of a company that predated the Civil War. On the other hand, Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) pays CEO Warren Buffett just $175,000 in total compensation. Because most of his wealth is tied up in company stock, his incentives are aligned with Berkshire's long-term financial health rather than short-term performance.

4. Steep valuations
Many of the worst-performing stocks were trading at steep premiums -- the median was an eye-popping 22 times sales -- made all the more absurd because they were so unprofitable.

Case in point: Charter Communications
Chaired by legendary Microsoft co-founder Paul Allen, Charter became the nation's fourth-largest cable provider. It raked in almost $4 billion in annual revenue and added broadband subscribers at a breakneck 10,000 per week.

By 2005, cable modem subscriptions had surged from 608,000 to nearly 2 million, and the company was making distribution deals with popular TV stations, including ESPN, and major telcos Level 3 (NASDAQ:LVLT) and Sprint.

But despite management's insistence in 2005 that it had "moved the company forward" by "tak[ing] advantage of exciting new opportunities" that would "create new standards of excellence" and "unlock unrealized value," we have been warning investors for years not to touch Charter with a 10-foot pole. As we wrote in January 2005:

• Massive debt. Net debt (debt minus cash) is above $18 billion.
• Net debt is 28 times the company's market cap of $640 million.
• Charter was GAAP unprofitable, with $1.5 billion in yearly interest costs.
• Debt covenants posed a serious threat to the company's survival.
• The SEC had launched an investigation into Charter's accounting practices.
• Heavy spending for a cable infrastructure hadn't yielded high enough returns.

Charter's chronic inability to earn profits on the nearly $15 billion in capital expenditures the company has made in its existence, plus an absurd $21 billion debt burden, have finally caught up: In 2008, management proved unable to keep "the company moving in a positive direction" and announced that it will file for bankruptcy protection by April Fool's Day.

"Some more color"
Now compare that story with the 10 best stocks since the last recession, a list that includes outperformers like Apple (NASDAQ:AAPL), priceline.com, and Gilead Sciences.

Here are those numbers again:

Data from Capital IQ, a division of Standard & Poor's.

The contrast is revealing, and it shows that savvy investors can make a lot of money today if they look for companies that:

• Are profitable.
• Have limited debt.
• Don't overpay their executives.
• Trade at a reasonable valuation.

At Motley Fool Stock Advisor, we scour the markets for great companies exhibiting these characteristics. You can see what we're recommending today, as well as our top five stocks for new money, with a 30-day free trial.

Click here to get started. There's no obligation to subscribe.

This article was originally published Feb. 19, 2009. It has been updated.

Ilan Moscovitz owns shares of Apple and Berkshire Hathaway. Apple, priceline.com and Berkshire Hathaway are Motley Fool Stock Advisor recommendations. Microsoft, Sprint, and Berkshire Hathaway are Inside Value selections. The Motley Fool owns shares of Berkshire and has a disclosure policy.