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 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 that 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 (EPS) that are double or more the 10-year average.

Using Montier's three criteria, I ran a screen on all the stocks in the Russell 3000 and came up with 36 results. The following table contains seven of them:

*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 Aug. 24, 2010.

A surprise guest
I was surprised to find two exchange operators show up on the list (Intercontinental Exchange, NYSE Euronext), as this is a sector I generally find attractive. Perhaps I'm mistaken -- or perhaps this simply illustrates that mechanical screens are inherently limited when it comes to analyzing individual companies. For example, Montier's 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.

As the following table demonstrates, for companies such as Green Mountain Coffee Roasters (Nasdaq: GMCR) and Cognizant Technology Solutions (Nasdaq: CTSH), that have produced 10-year annualized EPS growth of 30% and 43%, respectively, both criteria could certainly produce a false positive:

*As of Aug. 24, 2010. Source: Capital IQ, a division of Standard & Poor's.

Safety first
With that said, the results should give investors pause. Cyclical or not, if you own any of the stocks in the first table, it may be worth revisiting your analysis in light of these results. Even if you don't own the stocks, the screen could do more than help you avoid losses; instead, it could be a source of profitable "short" ideas (selling a stock short involves selling borrowed shares with the goal of replacing them by buying them back later at a lower price and pocketing the difference in price).

Earning attractive returns in a bear market
Montier's screen is not the only way to identify "ticking time bomb" stocks. John Del Vecchio has spent 5 years developing a model to zero in on profitable short opportunities. In his free report, 5 Red Flags – How to Find the BIG Short, John discusses five indicators that are part of that model, which is battle-tested: As the manager of the Ranger Short Only portfolio from 2007 to 2010, Del Vecchio outperformed the S&P 500 by 40 percentage points.

If you are interested in applying a proven methodology to earn attractive returns in this secular bear market, just enter your email in the box below and you can get started with this free report.