Permanent loss of capital vs. stock price drop

7 Stocks That Could Cause Permanent Losses
By Alex Dumortier, CFA
February 12, 2009 Comments (1)

In a recent research note to clients, 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 assets.

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:

1. Either your cost basis was materially higher than the intrinsic value, or
2. 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 smooths 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 of greater than 16.

2. Balance sheet / financial risk: Excessive leverage can put 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 contracting 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 in which companies run a significant risk of bankruptcy.

3. Business / earnings risk: If current earnings are significantly higher than their recent historical average, investors may extrapolate 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 19 mid- and large-cap U.S. stocks. The following table contains seven of them:

Stock
Adjusted Price/ Earnings Ratio*
Z-Score
Current EPS/ 10-year Average EPS*

Wynn Resorts (Nasdaq: WYNN)
73.3
1.32
5.8

CME Group (Nasdaq: CME)
29.9
0.69
2.6

XTO Energy (NYSE: XTO)
26.4
1.44
2.6

Transocean (NYSE: RIG)
26.2
1.74
6.9

Williams (NYSE: WMB)
24.0
1.20
2.5

NYSE Euronext (NYSE: NYX)
18.5
1.39
2.6

Norfolk Southern
17.5
1.79
2.11


*Note that, in certain cases, the average earnings were calculated over fewer than 10 years for lack of data. Source: Capital IQ, a division of Standard & Poor's, as of Feb. 3, 2009.


A couple of surprise guests
I was surprised to find exchange operators CME Group and NYSE Euronext on the list, as theirs is a sector I find attractive right now. Perhaps this illustrates one of the limitations of mechanically screening by adjusted P/E and comparing current earnings to the 10-year average: It doesn't allow you to distinguish between secular increases (or declines) in earnings and cyclicality. Both companies became publicly traded within the past 10 years, so their focus on profit growth is boosted.

Here's an extreme example: Google's (Nasdaq: GOOG) earnings per share have, on average, doubled every year over the past five years; in this instance, it's pretty clear that using the 10-year average EPS to calculate the P/E would actually muddy the waters. An average earnings figure calculated over a period of strong growth is inadequate to describe the company's true earnings power at the end of the period.

Safety first
All the same, the results should give investors pause -- the other companies in the table are clearly cyclical, particularly those in the energy sector (Transocean, XTO Energy, and Williams). 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 their members sidestep sinkholes and invest in well-run, well-capitalized businesses trading at cheap prices.

Fool contributor Alex Dumortier, CFA, has no beneficial interest in any of the companies mentioned in this article. Google and NYSE Euronext are Motley Fool Rule Breakers picks. The Motley Fool has a disclosure policy.

http://www.fool.com/investing/value/2009/02/12/7-stocks-that-could-cause-permanent-losses.aspx