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 at which they trade and punish the Dumpster-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

(out of 5)

2004 Book Value

Return Since

Dynegy (NYSE: DYN  )

****

0.67

(50.6%)

Waste Services (Nasdaq: WSII  )

**

1.55

(71.5%)

Ambac Financial (NYSE: ABK  )

*

1.88

(98.9%)

KB Home (NYSE: KBH  )

*

1.80

(67.6%)

MSC Software (Nasdaq: MSCS  )

*

1.16

(41.9%)

Sources: Motley Fool CAPS, Capital IQ. Book value as of March 20, 2004.

Watch out!
How can you avoid value traps like these? My favorite method is borrowed from professor Aswath Damodaran, 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 for when you're in the weeds
Our 130,000-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 with returns on equity of 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 216 stocks that CAPS found hiding in the weeds, it's ArcelorMittal (NYSE: MT  ) that intrigues me this week. The details:

Metric

ArcelorMittal

Recent price

$18.42

CAPS stars (out of 5)

*****

Total ratings

1,451

Percent bulls

97.2%

Percent bears

2.8%

Price-to-book ratio

0.47

ROE

16.8%

% above 52-week low

19.3%

Sources: CAPS, Yahoo! Finance, Capital IQ. Data current as of March 23, 2009.

Talk about an intriguing collection of numbers. Not only does ArcelorMittal trade on the cheap when it comes to book value, it's also a very efficient deployer of equity.

Yet the company's high returns on equity may have more to do with acquiring debt than boosting efficiency. Mittal took on billions to acquire Arcelor in 2006, and the new entity, which owes nearly $34 billion at last count, recently reported its first-ever quarterly loss since the companies joined.

"[ArcelorMittal] has very diversified operations geographically.... They [are] an industry leader, and will benefit from the global turn around. US Steel (NYSE: X  ) is a good play too, but [ArcelorMittal] has better fundamentals," wrote CAPS All-Star rpgizzle.

Recent comments from the company lend credence to this thesis. "Arcelor Mittal has a successful debt reduction programme in place and does not need to raise additional capital through a rights issue at this time," management said in a recent statement meant to squash rumors that it would sell stock to reduce debt.

Do you believe them? Would you buy ArcelorMittal 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 for 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.

Fool contributor Tim Beyers is a member of the Rule Breakers team. Tim didn't own shares in any of the stocks 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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