Don't Miss This Cheap Stock

Cheap stocks can get cheaper. They often do.

Unfortunately, "cheap" is a relative term. Precious few stocks that trade for low price-to-earnings ratios or below book value are real bargains. They look enticing but are instead value traps -- stocks that deserve the multiples for which they trade and punish the trash-can-divers who buy them.

But don't take my word for it. Here are five "cheap" stocks that trapped bargain-hunting prey:

Company

CAPS Stars

(5 max)

2004 Book Value

Return Since

Provident Energy Trust (NYSE: PVX  )

****

1.29

(23.7%)

Exar (Nasdaq: EXAR  )

***

1.47

(64.9%)

Weyerhaeuser (NYSE: WY  )

***

1.93

(54.6%)

Deutsche Telekom (NYSE: DT  )

***

1.97

(15.2%)

Cox Radio (NYSE: CXR  )

*

1.77

(85.1%)

Sources: Motley Fool CAPS, Capital IQ.

Watch out!
How can you avoid value traps like these? My favorite method is borrowed from Aswath Damordaran, author of Investment Fables. In it, he counsels investors to measure low price-to-book stocks by their returns on equity (ROE).

Makes sense to me. Book value is shorthand for equity. A low price-to-book stock is priced as if management won't produce high returns from the equity capital afforded it. Find a stock that defies this maxim -- a stock with an above average and rising ROE -- and you may have found a bargain.

A machete when you're in the weeds
Our 130,000-member Motley Fool CAPS community is a great place to start your search. I ran a screen for well-respected stocks trading for less than twice book value and whose returns on equity were 10% or more. Contenders were also trading no more than 25% above their 52-week low, leaving plenty of room for further gains.

Of the 279 stocks that CAPS found hiding in the weeds, it's longtime Motley Fool Income Investor recommendation Southern Company (NYSE: SO  ) that intrigues me this week. The details:

Metric

Southern Company

Recent price

$27.14

CAPS stars (5 max)

****

Total ratings

566

Percent bulls

92.8%

Percent bears

7.2%

Price-to-book

1.57

ROE

13.0%

% Above 52-week low

2.5%

Sources: CAPS, Yahoo! Finance, Capital IQ.Note: data current as of March 15, 2009.

There's something tempting about an entrenched utility that yields more than 6% and which is trading within spitting distance of its 52-week low. Sure, Southern could fall to lower lows as Entergy (NYSE: ETR  ) did on Friday, but there's reason to believe that this stock will be a winner over the long haul.

At least that's how my Foolish colleague Todd Wenning sees it. Todd created the TMFHighYield portfolio of dividend stocks -- equities that he believes will steadily increase dividend payouts and produce enormous wealth for their owners. Southern Company is in the portfolio.

And why not? Even bears like CAPS investor Cicciano find little to dislike when it comes to Southern. Quoting from this Fool's December pitch:

A great company, a sweet dividend -- good solid conservative investment -- but it is a utility. A great place to find refuge on the way down, but the market will outpace this the next couple of years (OK, maybe not 2009....)

I'm thinking longer-term. And, for the long haul, I see Southern heading north. But that's my opinion. I'm more interested in what you think. Would you buy Southern Company at today's prices? Let us know by signing up for CAPS today. It's 100% free to participate. See you back here next week with more bargain-basement Foolishness.

Fool contributor Tim Beyers is also a member of the Rule Breakers team. Tim did not own shares in any of the stocks mentioned in this article at the time of publication. Southern is a Motley Fool Income Investor selection. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. The Motley Fool is also on Twitter as @TheMotleyFool. Its disclosure policy is a bargain at any price.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 16, 2009, at 5:31 PM, rsk2 wrote:

    If PVX was such a trap, why did you recommend it 10-12 months ago?

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