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 Stars (out of 5)

2004 Price-to-Book Ratio

Return Since

KeyCorp (NYSE: KEY  )

**

1.96

(79.4%)

Ford Motor (NYSE: F  )

**

1.77

(39.8%)

Freddie Mac (NYSE: FRE  )

*

1.71

(97.8%)

Redwood Trust (NYSE: RWT  )

*

1.71

(57.1%)

D.R. Horton (NYSE; DHI)

*

1.93

(44.0%)

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 140,000-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 37 stocks that CAPS found hiding in the weeds, Florida utility FPL Group (NYSE: FPL  ) intrigues me this week. The details:

Metric

FPL Group

Recent price

$50.09

CAPS stars (out of 5)

*****

Total ratings

964

Percent bulls

96.8%

Percent bears

3.2%

Price-to-book

1.68

ROE

15.6%

% Above 52-week low

20.8%

Sources: CAPS, Yahoo! Finance.
Data current as of Oct. 29.

Utilities aren't typically where you'll find sexy growth. Yet few stock market stories are sexier than clean energy, and FPL has found a page within the narrative.

"I like FPL as a long-term bet on alternative energy," wrote CAPS investor GonzoDeluxe recently. "They are a traditional utility company, so they will benefit from the shift as motor vehicles move into hybrid and battery powered tech, plus they are moving aggressively into wind power and some solar. They could also benefit from their experience with nuclear power as new nuclear permits start to pick up again."

Also, at 10 times earnings, FPL trades for a discount to other regional utilities, such as Southern Company (NYSE: SO  ) . Mix in a healthy 3.8% dividend yield, and you've got a potential winner in the making.

But that's my take. What would you do? Would you buy shares of FPL Group 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. Southern Company is an Income Investor 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 (1) | Recommend This Article (4)

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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 October 30, 2009, at 6:42 PM, chasman143 wrote:

    Being new to the 'hands-on' investment arena, I want to glean from others views. I did not vote for our current president, but I believe we will move increasingly toward subsidized 'clean' energy sources and the like. Kind of like section8 housing, taxpayers foot the bill. Not a judgement on its value, just a perspective. Money will flow into 'clean' energy, through subsidies if need be. So I agree that certain, well-heeled (so to say) utilities will find priviledge and profit pursuing a product that would not fly in a 'free-market economy'. There would be no price point to sell it, where others would buy. I look forward to reading the results of your (and others) research toward this end. I am not going to change how these companies get ahead...but I want to get in on the profit.

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