3 Toxic Value Stocks to Avoid in 2017

By Sean Williams Markets Fool.com

Image source: Getty Images.

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Don't look now, but in less than four weeks 2016 will be in the rearview mirror. While it began about as horribly as you can imagine, with all three major U.S. indexes losing at least 10% of their value through mid-February, it looks to end on a high note, with all three indexes hitting new all-time highs.

Despite general bullish market sentiment, there are still quite a few value stocks that appear ripe for the picking. While there's no concrete definition of a value stock, typically we're talking about companies with a notably lower price-to-earnings ratio to their peers and the stock market in general. In other words, companies with single-digit P/E ratios and/or PEG ratios around or below 1.

Under normal circumstances, value stocks can be great for hedging your downside risk, because they're presumably "cheap" to begin with. Plus, according to a 90-year study by Bank of America/Merrill Lynch, value stocks have outperformed growth stocks on an annual basis to the tune of 17% growth to 12.6% growth. But, not all value stocks are created equally. Some, despite their relative cheapness, are downright toxic.

Here are three toxic value stocks you'd be wise to avoid in 2017.

Valeant Pharmaceuticals

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If you haven't closely monitored the turmoil at drugmaker Valeant Pharmaceuticals (NYSE: VRX), then the simple fact that it's valued at three times its forward earnings and about 1.5 times its annual EBITDA makes it look like the steal of the century. Unfortunately, the only thing Valeant has been stealing is the hard-earned money of investors.

Valeant has three main issues at its core: debt, legal issues, and business model degradation.

Image source: Getty Images.

Valeant ended the third quarter with $30.4 billion in debt, mostly as a result of financing numerous deals to acquire businesses and drugs over the last couple of years. When Valeant's pricing practices were formally questioned by Washington lawmakers and its top and bottom line were adversely impacted, lenders cut off Valeant's access to additional credit. Now, with $30.4 billion in debt, Valeant has little choice but to sell some of its assets. If the company chooses to sell non-core assets, it risks not making a big enough dent in its debt load. If it sells its core assets, such as Bausch & Lomb or Salix Pharmaceuticals, it'll knock out a good portion of its debt, but it'll also cripple its growth prospects moving forward. As icing on the cake, it's struggling to get a fair value for its assets since its peers are well aware of its debt woes and are unwilling to pay a premium.

Secondly, Valeant is still under investigation by federal prosecutors for its relationship with Philidor Rx Services, an owned entity that distributed drugs for the company. If Philidor wasn't disclosing its relationship with Valeant to insurers and remaining a neutral party and Valeant's executives were aware of this, then it could result in fines and/or sales restrictions for Valeant.

Valeant is also dealing with a severe slowdown in its flagship dermatology business, and a general malaise throughout much of its prescription drug business. Some of the blame lies with the bad PR it's dealt with, which may be turning physicians and consumers off of its products. Additionally, its new drug distribution deal with Walgreens Boots Alliancehasn't worked out as planned, with Valeant having to pay Walgreens through the nose (and in some cases) filling prescriptions at a loss).

Valeant's laundry list of concerns make it a toxic value stock to keep far away from your portfolio in 2017.

Staples

Office supply superstore Staples (NASDAQ: SPLS) is bound to turn the heads of value and income investors with a forward P/E of less than 11 and a dividend yield of 5%. But, push the "easy button" on this stock and you're liable to easily lose money.

Image source: Staples.

Staples is being eaten alive by e-commerce giants like Amazon.com (NASDAQ: AMZN), which have feasted off of show-rooming and their lower-cost structure. Online websites like Amazon are able to offer convenience and choice that consumers simply can't get from a brick-and-mortar Staples store. In instances where consumers or businesses want to test products out before purchase them, they're using Staples as the showroom, and then buying the products online through Amazon or another e-commerce retailer (i.e., show-rooming). Because it lacks the brick-and-mortar presence, Amazon also tends to have lower overhead costs, resulting in its ability to undercut Staples' pricing.

For its part, Staples has been selling off what it deems non-core components of its long-term business, and it's also been shutting down some of its larger underperforming stores. Through the third quarter, Staples had closed 35 stores in 2016, and it was well on its way to shuttering 50 stores in total this year. Unfortunately, cost-cutting can only sustain margins, so if revenue keeps falling, profits are likely to continue declining as well.

At the same time, Staples has refocused its efforts on North America, and it's reinvesting heavily in Staples.com. What's truly sad is its reinvestment in Staples.com hasn't helped much because the Staples brand has begun to lose its luster among small businesses. In North America, comparable-store sales fell 4% overall, while Staples.com's constant currency sales fell 1%. That's right, Staples actually saw its e-commerce sales decline in Q3 while nearly all of its peers are seeing significant e-commerce growth. This tells you everything you need to know about Staples' prospects, and it gives value and income investors every reason to avoid the stock in 2017.

GameStop

Another deeply discounted and potentially toxic value stock worth avoiding in 2017 is video game and accessories retailer GameStop (NYSE: GME), which is valued at a forward P/E of just six and is sporting a 6% dividend yield.

Image source: GameStop.

For more than a decade GameStop was a dominant force in gaming. When new consoles came out and games were released, it was the one-stop shop to procure these items. Today, it's somewhat of an afterthought. One of the bigger issues for GameStop is that it requires innovation to thrive, and it just takes far too long to bring innovative new consoles to market. Generally speaking, console replacement happens about every six years, which means for only one of those years is GameStop ever truly busy and knocking down Wall Street's estimates. One good year out of every six years isn't enough reason to own this stock.

Additionally, gaming is shifting aware from physical discs and toward digital, which could leave GameStop on the outside looking in. This isn't to say that GameStop hasn't made investments in mobile and digital, or that it hasn't bundled digital software with physical game purchases, but its brick-and-mortar locations are still ill-prepared to compete with low-cost digital competitors.

In its recently reported third-quarter results, technology brand sales jumped 54%, but they still made up only 11% of total revenue. This means the standard brick-and-mortar business, minus technology brands, witnessed a disappointing 6.5% dip in same-store sales from the prior-year period. This followed a 1.1% decline in same-store sales in Q3 2015 from Q3 2014.

GameStop's only means to keep investors happy has been to pay out a healthy dividend, reduce costs via store closures, and repurchase its stock to boost EPS. This strategy can only mask its lack of true profit growth for so long, and I would encourage value stock seekers to keep their distance from GameStop in the upcoming year.

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Sean Williamsowns shares of Bank of America, buthas no material interest in any other companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.

The Motley Fool owns shares of and recommends Amazon.com and Valeant Pharmaceuticals. It also has the following options: short January 2017 $28 puts on GameStop. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.