The stock market has gone through a powerful rally over the past year. But that doesn't mean that stocks will stay up forever. The next downturn might be right around the corner.
More importantly, some companies never rebounded in the aftermath of the financial crisis. In trying to protect your money, how can you differentiate between general fluctuations in the market and permanent losses of capital?
Permanent capital loss: a definition
A permanent loss of capital occurs when a stock goes down because of deteriorating business operations, and stays down for a very long time, or even forever. For example, if a company goes bankrupt, or its earnings power drops permanently, then shareholder value will also become permanently impaired.
Want to avoid these dreaded losses? These Foolish tips might help you.
Avoid leverage
Leverage magnifies gains and losses, and can make temporary setbacks permanent. Earlier in this decade, homeowners betting on rising home prices borrowed a lot of money that they couldn't afford.
Of course, in the long term, home prices will rise again. But now, prices have tumbled, and the surplus of inventory and lack of easy credit has left investors without any buyers for the real estate they purchased. Consequently, many investors who leveraged their purchases too heavily have been forced to give up their homes. Thus, this temporary downturn in the housing industry has become a permanent loss for many investors.
Countrywide Financial is a textbook case in which shareholders suffered a permanent loss of capital, in large part because of excessive leverage. Founded in 1969, the company was renowned for its history of surviving brutal real estate and mortgage cycles. It eventually became the largest mortgage lender in the U.S.
However, Countrywide's nearly four decades of successfully navigating those cycles stopped dead when excessive use of debt left the company with an evaporating margin of error. Using a simple measure of leverage (assets divided by equity), the numbers (in millions) tell the tale:
|
Metric |
1993 |
1997 |
2002 |
2006 |
|---|---|---|---|---|
|
Assets |
3,299.1 |
7,689 |
58,030.7 |
199,946.2 |
|
Equity |
693.1 |
1,611.5 |
5,161.1 |
14,317.8 |
|
Assets/Equity |
4.8 |
4.8 |
11.2 |
14.0 |
Many factors contributed to Countrywide's downfall, but excessive leverage clearly played one of the largest roles in forcing Countrywide to sell itself at a low price to Bank of America (NYSE:BAC).
Avoid obsolescence
As new technology rolls in, outmoded ideas fade. The rise of the Internet made big winners out of popular online companies like Yahoo (NASDAQ:YHOO) and Amazon.com (NASDAQ:AMZN). But as this new method of obtaining data rapidly spread, Internet users abandoned newspapers. The loss of traditional newspaper readers might be permanent, severely impairing the industry's earning power.
Shareholders who didn't anticipate the newspaper's gradual obsolescence, and bought shares of New York Times (NYSE:NYT) around $50 per share back in 2004, have probably suffered a permanent impairment of capital. Shares now languish around $12 per share. Other newspaper publishers, such as Gannett (NYSE:GCI), have suffered similar declines.
Understanding where a company is in the life cycle of its industry is crucial for an investor. Companies that lose competitiveness to new technologies might never recover. That dissolution will result in a permanent loss for investors who arrive too late to the party.
Avoid shrinking moats
In addition to leverage and obsolescence, a shrinking moat can also permanently impair shareholder value. Warren Buffett, chairman of Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B), purchased Dexter Shoe, a U.S. shoe manufacturer, in 1993. However, the shoe industry was in the process of being outsourced to Asia, where manufacturers using cheap labor could severely undercut domestic producers.
Even the best investors make mistakes, and Buffett later noted that purchasing Dexter was clearly an error on his part, due to its dwindling competitive advantages.
Beware of "bargain" stocks
Even after the big run-up, many stocks have still lost substantial ground over the past two years. Many investors are still sitting on some fairly large losses. Many of those stocks are down because of overall market volatility; their prices will eventually reverse as our economy strengthens over time. However, some stocks may be down for reasons beyond general market movement.
It's important for investors to distinguish how companies stand relative to these conditions, and whether the ones that are selling now are true values with the potential to rebound.
