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 filing for bankruptcy protection.

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 24 mid- and large-cap stocks trading on major U.S. exchanges. This 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 Jan. 6, 2010.

A couple of surprise guests
I'm surprised that railroad Norfolk Southern shows up on the list, as this is a sector super-investor Warren Buffett finds attractive. So much so, that his company, Berkshire Hathaway, announced last November that it would acquire Burlington Northern in the largest deal in its history. At the end of the third quarter, Berkshire also owned 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 individual 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 companies such as Netflix (Nasdaq: NFLX) or Apple (Nasdaq: AAPL), which  have grown diluted earnings per share at an annualized rate of 45% and 79%, respectively, over the past 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 its 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 the five best recommendations for new money now, take advantage of a 30-day free trial today by clicking here.

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

You can follow Fool contributor Alex Dumortier on Twitter; he has no beneficial interest in any of the companies mentioned in this article. Berkshire Hathaway and Chesapeake Energy are Motley Fool Inside Value recommendations. Apple, Berkshire Hathaway, and Netflix are Stock Advisor picks. The Fool owns shares of Berkshire Hathaway and Chesapeake Energy. The Motley Fool has a disclosure policy.