The 10 Worst Recession Stocks

I recently 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 the 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 stocks delisted as of January 2009. 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 Verenium (NASDAQ:VRNM) and Freeport-McMoRan (NYSE:FCX), both of which fell by some 20% during the recession … but which by the end of 2008 fell 95% and rose more than 185% respectively.

That's why, back in August, 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 generally, you 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 -- and therefore had a negative ROE.

2. Too much debt
Several of the worst stocks had onerous debt loads. Too much debt limits a company's ability to take profitable 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 and Lehman Brothers were some of the hardest hit, while many moderately leveraged banks like BB&T (NYSE:BBT) and US Bank (NYSE:USB) suffered much less.

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 management lacks 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, Warren Buffett earns just $175,000 in annual compensation. Because most of his wealth is tied up in company stock, his incentives are aligned with long-term shareholders rather than short-term performance. Markel’s (NYSE:MKL) Alan Kirshner has an incentive structure that resembles Buffett’s much more closely than do many of his peers’.

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 networks including ESPN and major telcos such as Level 3, and was even competing against big names like AT&T (NYSE:T), known at the time as SBC.

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 lifetime capital expenditures, plus an absurd $21 billion debt burden, finally caught up: Management proved unable to keep "the company moving in a positive direction" and filed for bankruptcy protection in early 2009.

"Some more color"
Now compare that story with the 10 best stocks since the last recession, a list that includes outperformers like Southwestern Energy, Gilead Sciences, and Range Resources (NYSE:RRC).

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.

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

Ilan Moscovitz owns shares of US Bank. Microsoft and Markel are Motley Fool Inside Value recommendations. The Fool owns shares of Markel and has a disclosure policy.