Strategy for Survival

 | Oct 03, 2013 | 3:30 PM EDT
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As much as I love finding cheap stocks, I devote a fair amount of attention to avoiding issues that can leave me with a permanent impairment of capital. Owning a stock that Wall Street is in love with can cause devastating losses when the relationship sours and institutions rush for the door.

Sometimes identifying these names can be very easy. Stocks with triple-digit earnings ratios such as Tesla (TSLA) and Netflix (NFLX) may be exciting to own in the short run, but in a down market they will lead the way lower and may not recover for years. Look at tech stocks in 1999 and big banks in 2007 and you get an idea of what a permanent impairment to capital looks like.

Others stocks that present a very high risk may not be as obvious. Fortunately, we can use the same tools that are useful in finding cheap stocks with recovery potential to discover seemingly solid stocks that might pose a risk of permanent capital impairment. By inverting the process, we can look for stocks that are doing well but show that the company itself has low Piotroski F scores and Altman Z scores, which indicate it may be headed for financial and operating difficulties in the near future.

The time to shed these stocks from your portfolio is before the problems become obvious to the rest of the world and the stock tumbles sharply. Even if disaster does not strike, stocks with poor fundamentals are probably not going to be strong performers, so it is best not to own them.

CBS (CBS) is a great example of such a stock. The company's dispute with Time Warner Cable (TWC)is behind it and the spinoff and IPO of its outdoor advertising division is on track. Investors have been buying the shares again. The bulls' argument makes some sense, as with its NFL season, CBS has some of the strongest prime time offerings on television. We are also coming into the midterm election year, which could be a boon for ad sales and rates for broadcast media. The stock has been a strong performer and is up more than 50% over the past year.

But the numbers are telling us a far less attractive story. The company has a current ratio of just 1.2 and the Altman Z score is at .77. This is well below the 2.99 that indicates financial safety. Its F score of 4 indicates that the fundamentals are actually deteriorating somewhat. Trading at 19x earnings, the stock does not appear horribly priced, but conditions could easily turn and there is absolutely no margin of safety. I was big fan of this stock when it was trading below $5 in 2009, but I can see no reason to own the shares now that they have moved up by tenfold and business conditions are less than wonderful.

Investors have been enamored of power management concern Eaton (ETN) and have bid the shares up 50% in the past year. The company is digesting the Cooper acquisition, which is driving higher sales; however, is not really doing much for the bottom line. A sluggish global economy is going to make for flat line profits for the next year or two and the long-term outlook calls for single-digit sales and earnings growth at best.

Trading at 20x earnings and 2x book value might not seem like a horrific price to pay but it is steep for a company with limited growth opportunities. In addition, its F score of 4 tells us that the company seeing deteriorating conditions. The Z-score of 1.76 does not predict the imminent demise of the company but does tell us that the increased debt levels at the company are pricing a headwind. Eaton is a good business but the stock is neither cheap nor safe at current levels.

Finding big winners is a profitable and fun activity for long-term investors but avoiding those issues with the potential for big losses is just as important. As Andrew Lo advised in his Adaptive Market Hypothesis, the most important job of a long-term investor is to survive.

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