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)

2005 Price-to-Book
Ratio

Return Since

Ferro (NYSE: FOE  )

****

1.50

(57.5%)

iStar Financial (NYSE: SFI  )

***

1.97

(91.5%)

Regions Financial (NYSE: RF  )

**

1.40

(75.9%)

Unisys (NYSE: UIS  )

**

1.70

(54.9%)

Krispy Kreme (NYSE: KKD  )

*

1.06

(62.5%)

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 145,000-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 42 stocks that CAPS found hiding in the weeds, water engineering services provider Tetra Tech (Nasdaq: TTEK  ) intrigues me this week. The details:

Metric

Tetra Tech

Recent price

$20.79

CAPS stars (out of 5)

****

Total ratings

381

Percent bulls

96.3%

Percent bears

3.7%

Price-to-book

1.9

ROE

13.3%

% Above 52-week low

6.6%

Sources: CAPS, Yahoo! Finance. Data current as of Feb. 7.

Two numbers captivate me. First, return on capital has remained steady at or above 12% over the past two-and-a-half years -- well above what higher-priced peer Shaw Group (NYSE: SHAW  ) earns. Second, at 16.7 times normalized earnings, Tetra Tech is trading for a multiple not seen since November 2008.

Poor short-term earnings and guidance are to blame for the discount. Last month, the company reduced its 2010 earnings guidance due to what CEO Dan Batrack in a press release said was the "slow pace of stimulus spending."

CAPS investors have mostly used the news as a buying opportunity. Of the 48 who've rated the stock since that Jan. 27 report, only three have said it would underperform. All-Star tenmiles called Tetra Tech a long-term buy at $20 per share. I agree.

How about you? Would you buy shares of Tetra Tech at today's prices? Let us know by signing up for CAPS today. It's 100% free to participate.

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. You can 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. 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 (10)

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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 February 08, 2010, at 10:52 AM, NASDAQCZAR wrote:

    Krispy Kreme Doughnuts KKD has strong growth prospects and now a lean mean profitable company. KKD will open nearly 100 new stores in 2010 and has the best upside potential of any stock. KKD price target is $13 by years end. KKD will be debt free by 2011 and in cash-flow free positive.

    KKD has only has 563 stores and has lots of room to grow. KKD is your best bet to profit in 2010. KKD is a winner and will easily be the best percentage gainer for this year. Small caps like KKD will outperform the large caps like the article says. KKD is also a likely takeover candidate. KKD is worth north of $13 a shareKrispy Kreme Doughnuts KKD price target is $13 by year end. KKD is your best bet to profit in 2010. KKD is now profitable a lean mean company. Smaller more profitable stores for Krispy Kreme. KKD will open 100 new stores in 2010. KKD is a growth stock once again and has the best upside of any stock in 2010. KKD should be the percentage winner for stocks ahead of large caps in 2010.

    KKD is a winner with strong growth prospects and is cash-flow free positive as well will be debt free by 2011. I agree KKD will outperform large caps which have no growth prospects like the article mentions. Buying KKD is like buying Coke or Mcdonalds 30 years ago. KKD is also a likely takeover candidate that would be a large premium paid to KKD shareholders. Go KKD!

  • Report this Comment On February 08, 2010, at 11:04 AM, NASDAQCZAR wrote:

    Krispy Kreme Doughnuts Upgraded KKD 1-1 Rating Strong Buy Overweight Portfolio in Krispy Kreme Doughnuts stock Target Raised to $13 Record Growth 100 New Stores Opening in 2010 EOM

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