In theory, there are no givens when it comes to investing in the stock market. If there were, we would all be rich and retired on the beach by now.
But the closest thing the stock market does have to a "certainty" is that market valuations, as a whole, tend to increase over time. Since 1950, based on data aggregated by Yardeni Research, there have been 35 corrections of at least 10% when rounded to the nearest integer. In each and every instance since 1950 the stock market has rallied -- within weeks, months, or in rarer cases, years -- to completely erase any trace of a downturn. This means any notable sell-offs in the global stock market, such as what happened following the Brexit vote, tend to be a good time to long-term investors to pick up stocks "on the cheap."
These value traps could wreck your portfolio
However, blindly buying assets that are perceived to be trading at "a good value" could be a mistake. Value traps, which are assets that look appealing based on a combination of metrics that could include price-to-earnings ratio, price-to-book ratio, or cash flow can be portfolio wreckers. If you aren't digging deep enough to understand why assets are priced the way they are, you could be missing the big picture.
Here are three of (what I perceive to be) the biggest investing value traps you'll want to avoid.
1. Long-term U.S. Treasury bonds
U.S. Treasury bonds are considered to be among the safest investments in the world since they're backed by the full faith of the United States government.
But interest on today's bonds is a far cry from what your parents and grandparents were able to garner. A precipitously long period of near record-low interest rates, as well as three rounds of quantitative easing that saw the Federal Reserve buying long-term U.S. Treasuries in an effort to keep interest rates down (remember, bond prices and bond yields are inverse to one another, so buying bonds pushes bond prices higher and yields lower) have the 30-year U.S. T-bond at a yield of just 2.24% through July 1, 2016.
On one hand, income-seeking investors might be eager to lock up a 2.24% yield given the recent stock market volatility. Then again, if we dig deeper we can see just how egregious a value trap the 30-year T-bond has become. The nominal inflation rate over the past 100 years has been north of 3%, meaning over 30 years there's a decent chance the 2.24% return could lose purchasing power to inflation. Furthermore, you'd need to hold for a full 30 years to realize the benefits of a long-term T-bond. Selling early, especially if yields rise, would result in your receiving far less of your principal back than you put in.
Yes, a long-term Treasury bond provides you with a guaranteed nominal return, but it's a dangerous value trap that could wind up costing you real money relative to inflation.
2. European banks
As a whole, the European banking sector appears downright cheap. Following the Brexit-related swoon, there are a bounty of EU-based banks trading at single-digit forward P/E ratios that could make investors drool. These include Deutsche Bank (NYSE:DB), at just 7.3 times forward earnings, and Banco Santander (NYSE:SAN) at 8.5 times next year's profit forecast.
But the European Union is a veritable mess following Britain's vote to leave the 28-nation organization, which means there aren't any near-term catalysts to suggest that things are going to get better for these aforementioned banks, or the sector as a whole, any time soon.
For example, Deutsche Bank is undergoing a complete revamp of its operations, with 2016 marking its peak year of restructuring. It's eliminating jobs in order to cut costs and attempting to simplify its business by selling off some aspects of its investment banking business. Recently, following the release of the 2016 Comprehensive Capital Analysis and Review (CCAR) by the Federal Reserve, Deutsche Bank was announced as one of two banks out of 32 that didn't pass the stress test. In other words, the Fed views Deutsche Bank as being undercapitalized.
For Spain's Banco Santander, the other bank that failed to pass the Fed's stress test, the big issue has been the ongoing underperformance of the Spanish economy. The loss of the U.K. from the EU exposes countries like Spain, Italy, and Greece, which have weaker economies and higher debt levels. These countries have become reliant on the stability of the EU to prop them up. Without Britain, there's once again uncertainty surrounding the possibility that Spain's economy could sink, which would have an adverse impact on Banco Santander.
What's more, Brexit probably crushes any chances lending rates had of heading higher. The German 10-year Bund currently has a negative yield, which requires German banks to pay the European Central Bank to hold cash! With no interest rate hikes on the horizon, interest-based income is likely to be stagnant for EU banks as a whole.
European banks look to be anything but a value right now.
3. Companies with thesis-altering events
The last investing value trap to avoid is being suckered in by companies with low current P/E ratios or high dividend yields that have recently reported an investment-thesis-altering event. Two cases in point that come to mind are Staples (NASDAQ:SPLS) and Valeant Pharmaceuticals (NYSE:BHC).
On the surface, office supply superstore Staples looks like an income or value investor's dream stock. It's trading at less than 10 times next year's profit expectations, and it's paying out a 5.6% yield, which is more than twice the current rate of inflation (and the interest on the 30-year T-bond).
But there's a reason Staples is valued so cheaply. In May, a federal judge officially blocked the merger between Staples and Office Depot (NASDAQ:ODP) that would have better allowed the two to compete against e-commerce giants like Amazon.com, which are undercutting traditional office supply stores on price and providing convenience to consumers who can shop from home. Without this cost-saving merger with Office Depot, Staples has reverted to plan B, which is to essentially close a bunch of stores, lay off workers, and continue to try to build up its direct-to-consumer sales. While cutting costs can help it maintain margins, fewer stores mean less revenue and less profits. That could call its generous dividend into question at some point down the road. With no clear growth catalysts, Staples looks like a potential portfolio wrecker.
Something similar could be said for drugmaker Valeant Pharmaceuticals, which is trading at a forward P/E of 2.6 -- and no, that's not a misprint. Its price/earnings to growth ratio of 0.4 and low forward P/E would imply to investors that Valeant could be an incredible bargain. Dig below the surface, however, and you'll see otherwise.
Valeant's business model from a year ago has essentially been blown up compared to what it is now. There are multiple probes looking into the company's drug-pricing practices, which could affect its pricing power, and Valeant is swimming in $31.3 billion in debt without access to additional lines of credit. Valeant's primary mode of growth had been to acquire new products or companies with the use of debt, but with its business model under a regulatory microscope, it's been unable to keep the M&A engine running. Now, with its profit forecasts falling and its EBITDA (earnings before interest, taxes, depreciation, and amortization) dangerously close to breaching debt covenants, it has little choice but to turn to asset sales. Mind you, it's no secret that Valeant is in trouble, so don't expect these asset sales to produce anywhere near a fair market value.
Long story short, companies with thesis-altering events can be dangerous value traps.