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 instead, they're 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 Rating (out of 5)

2004 Price-to-Book Ratio

Return Since

Dynegy (NYSE: DYN  )

****

0.84

(60.2%)

KeyCorp (NYSE: KEY  )

**

1.98

(79.8%)

USA Mobility (Nasdaq: USMO  )

**

1.85

(32.7%)

Entercom Communications (NYSE: ETM  )

*

1.79

(76.6%)

KB Home (NYSE: KBH  )

*

1.97

(70%)

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, Damodaran 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 database at Motley Fool CAPS, with 145,000 members, 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 13 stocks that CAPS found hiding in the weeds, securities market maker Knight Capital Group (Nasdaq: NITE  ) intrigues me this week. The details:

Metric

Knight Capital Group

Recent price

$15.60

CAPS rating (out of 5)

*****

Total ratings

314

Percent bulls

96.5%

Percent bears

3.5%

Price-to-book

1.23

ROE

13%

% Above 52-week low

16.5%

Sources: CAPS, Yahoo! Finance. Data current as of Dec. 31.

Knight Capital has suffered for many of the same reasons that NYSE Euronext (NYSE: NYX  ) has. Trading volume has proven volatile for much of 2009, and it recently fell from October to November, The Wall Street Journal reports.

Management's job isn't easy. Earlier this month, Knight's executives told analysts that the company faced margin pressure and promised cost cuts to compensate. CAPS investors largely believe these measures will produce value over the long term. They give the stock a five-star rating.

With the stock trading for less than 10 times trailing and forward earnings as of this writing, I'm compelled to agree. But that's also just my take. What would you do? Would you buy shares of Knight Capital 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 Motley Fool Inside Value service, which spotlights stocks that Mr. Market has put on sale. NYSE Euronext is a Rule Breakers recommendation. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Tim Beyers is also a member of the Rule Breakers stock-picking team. Tim 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.


Read/Post Comments (2) | Recommend This Article (7)

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 January 01, 2010, at 9:00 PM, paisedoog wrote:

    First Tim Beyers your title says don't miss this cheap stock. I then see DYN. Then you call it a cheap stock that trapped bargain hunting prey.

    The point is your title is deceiving. Your saying DYN is a trap. You use this to try to get people to buy Knight Capital.

    Please Be straightforward and honest.

  • Report this Comment On January 05, 2010, at 12:46 PM, Duke5343 wrote:

    Tim

    DYN is a cheap stock that has had the fungus of ENRON cling to them for the last 6 years, they are a sound company & I have made $ buying and selling since Nov. 08, should of bought more at $1 back in 08. Therefore I cannot fully agree they are a bad company to invest into at $1.90 or below. They are making good moves buying debit now and dumping their coal plants. if you bought at $9 in 2008 then yes they buned a few investors, but who did not get buned in mid 08 when buying when they should of been selling

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