Investing successfully over the long run can be quite simple, if you just stick with inexpensive broad-market index funds. Over many decades, the U.S. stock market has averaged annual returns of close to 10%. You can aim to outperform the market, though, by parking some or many of your dollars in individual stocks. But be careful -- a poorly chosen stock or two can make a big dent in your portfolio's performance.
One stock (well, two, really) that could destroy your portfolio is Fannie Mae, as well as its sibling company, Freddie Mac.
Currently, 100% of both companies' profits go straight to the U.S. Treasury, which is why shares are so cheap. However, pending lawsuits, if successful, could change this arrangement and give shareholders the massive payday they've been waiting for.
If the lawsuits are victorious, or if Congress miraculously decides to return the agencies to the shareholders, the value of the stocks could increase dramatically. In fact, according to a thorough analysis by Pershing Square (Fannie and Freddie's largest shareholder), shares could be worth between $23 and $47. The problem is that's a big "if."
Many lawmakers want to eliminate Fannie and Freddie altogether, which would likely wipe out the value of the stock. Even Republicans who favor allowing Fannie and Freddie to exit conservatorship are reluctant to do anything that could be perceived as a "bailout" to shareholders.
Essentially, the entire value of Fannie and Freddie's shares stems from the possibility that stockholders will eventually share in the agencies' profits. While that might happen, it's not a bet on which you should gamble a significant amount of your portfolio. Speculation like this is fine in small doses, and it can be rather fun, but you shouldn't do it with money you can't afford to lose. Allocating too much capital to Fannie and Freddie could destroy your portfolio if things don't work out favorably in court for shareholders.
Despite the strong economy, some companies are unable to make their businesses profitable and thus end up in bankruptcy. Yet even after a company files for bankruptcy, its shares often trade for months or even years while the process continues. For instance, hard-hit retailer RadioShack filed for bankruptcy protection in February. There's a deal in place to sell the company's locations to a hedge fund investor, and now all that's left is for the court to auction off its brand and other intellectual property. Yet even though any remaining value will almost certainly be used entirely to pay off creditors, shares still trade, and their price has oscillated between $0.10 and $0.34 in the past month alone.
That tempts some investors into thinking those shares might have real value, especially as the company approaches the end of the bankruptcy process and prepares to emerge from creditor protection. But even if a company stays in business after emerging from bankruptcy, old shareholders are typically wiped out, and newly issued stock goes to former creditors of the pre-bankruptcy business. Investing in bankrupt stocks is an almost surefire way to kill your portfolio, as most shares of bankrupt companies drop to zero as soon as the bankruptcy ends.
I so wish I could recommend Sears Holdings. The company has been an icon in American retailing, tracing its roots all the way back to the 1880s. Now encompassing Kmart as well, it's a big part of American history. But the sad truth is that the company is in deep trouble, and has been for quite a while.
Its annual revenue over the past decade fell from $50 billion to $31 billion. Its free cash flow, net income, and operating and net profit margins have all sunk well into negative territory. Want more? Its store count shrank from close to 4,000 in fiscal 2011 to just 1,725 at the end of fiscal 2014. Meanwhile, its long-term debt swelled from $1.7 billion to $2.9 billion. How will it repay all that debt? The company is generating some funds by selling off real estate into a REIT it created. But its properties represent a finite pool it can draw from, so that shouldn't encourage any investors.
CEO Eddie Lampert seems to be trying to unlock value in the company by breaking off parts -- it spun off Lands' End (NASDAQ:LE) last year -- but it's unlikely that he can dismantle the company into profitability. Meanwhile, the company has accelerated payments to suppliers, which is seen as a defensive move, assuring them they'll be paid to keep them from exiting.
Sears is not entirely devoid of value -- particularly in its own name and its Craftsman brand, among others. But it also needs a promising long-term strategy, and right now it's not giving investors much reason to be optimistic.
Go ahead and aim for above-average returns with individual stocks if you dare, but don't discount the riskiness of many stocks out there. Consider both the bull and the bear case for any portfolio candidate.