In a recent research note to clients, 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 notyour 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 causea 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 which 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 that are double or more the 10-year average.

Using Montier's three criteria, I ran a screen and came up with 25 mid- and large-cap stocks trading on major U.S. exchanges. The following table contains seven of them:

Stock

Adjusted Price / Earnings Ratio*
(Oct. 30, 2009)

Z-Score

Latest Annual EPS/10-Year Average EPS*

Covanta Holding
(NYSE: CVA)

206.0

1.19

10.8

IntercontinentalExchange
(NYSE: ICE)

93.5

0.42

3.9

Brocade Communications
(Nasdaq: BRCD)

80.1

1.68

4.0

Spectra Energy
(NYSE: SE)

29.5

0.86

2.8

Tyco Electronics
(NYSE: TEL) Continued...