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 garbage-grabbers who buy them.

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

Company

CAPS Stars (Out of 5)

2004 Book Value

Return Since

Modine Manufacturing (NYSE: MOD  )

***

1.79

(71.6%)

Chiquita Brands (NYSE: CQB  )

***

1.00

(40.5%)

Advanced Micro Devices (NYSE: AMD  )

**

1.63

(68.7%)

FuelCell Energy (Nasdaq: FCEL  )

**

1.76

(53.1%)

Hovnanian Enterprises (NYSE: HOV  )

*

1.88

(89.6%)

Sources: Motley Fool CAPS, Capital IQ, Yahoo! Finance.

Watch out!
How can you avoid value traps like these? My favorite method is borrowed from professor Aswath Damodaran. In his book Investment Fables, 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 for when you're in the weeds
Our 135,000-member-strong Motley Fool CAPS database 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. Qualifiers were also trading no more than 25% above their 52-week low, leaving plenty of room for further gains.

Of the 23 stocks that CAPS found hiding in the weeds, Consolidated Edison (NYSE: ED  ) intrigues me this week. The details:

Metric

Consolidated Edison

Recent price

$39.10

CAPS stars (5 max)

****

Total ratings

549

Percent bulls

96.0%

Percent bears

4.0%

Price-to-book

1.10

ROE

11.1%

% Above 52-week low

19.8%

Sources: CAPS, Yahoo! Finance.
Data current as of July 27, 2009.

Ask the Fools who like this New York utility for their portfolios, and chances are they'll praise it as a safe dividend play.

"[T]he company has raised dividends consistently for 35 years -- including February 2009," wrote CAPS investor helicopterfool in February:

Moreover, the stable nature of regulated power distribution have helped ConEd stockholders beat the broad market by more than 30 percentage points over the past year. It hasn't traded this low since March, 2005. It won't necessarily go to the moon, but it will beat the S & P.

Consistent dividend payers have a way of doing that, especially stocks whose yields far outpace the average yield of the broader market. Consolidated Edison yields an even 6% as of this writing.

But dividends are also no guarantee of success. Look at the bankers. Bank of America (NYSE: BAC  ) was a proven payer before the financial crisis. Do you trust ConEd's yield? Would you buy shares of Consolidated Edison at today's prices? Let us know by signing up for CAPS today. It's 100% free to participate.

More bargain basement Foolishness:

Want further guidance? Get 30 days of free access to the Fool's Inside Value service, which spotlights stocks that Mr. Market has put on sale. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Tim Beyers is also a member of the Motley Fool Rule Breakers stock-picking team. He didn't own shares in any of the companies mentioned in this article at the time of publication. Check out his 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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