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

Price Change
Since

Dynegy (NYSE: DYN  )

****

0.81

(63.1%)

STMicroelectronics (NYSE: STM  )

***

1.70

(56.4%)

KeyCorp (NYSE: KEY  )

**

1.94

(79.9%)

Redwood Trust (NYSE: RWT  )

**

1.48

(76.3%)

Webster Financial (NYSE: WBS  )

**

1.57

(65.9%)

Sources: Motley Fool CAPS and Capital IQ (a division of Standard & Poor's), as of Feb. 12.

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 150,000-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 38 stocks that CAPS found hiding in the weeds, energy equipment manufacturer Powell Industries (Nasdaq: POWL  ) intrigues me this week. The details:

Metric

Powell Industries

Recent price

$28.67

CAPS stars (5 max)

****

Total ratings

128

Percent bulls

89.8%

Percent bears

10.2%

Price-to-book

1.28

ROE

16.1%

% Above 52-week low

7.1%

Sources: CAPS. Data current as of Feb. 13.

CAPS investor dgtatu01 likes the long-term trend for Powell's business, per this pitch from last week:

I like this company a lot. They do the infrastructure work on electricity grids. Their business is down, but that is already fixed into the price. They have consistently grown earnings for the last 5 years and I predict they will be able to do this moving forward. A leaner 2010 will open into a lively 2011. ... [H]ang on for the ride.

Key numbers support that thesis. Both margins and returns on capital have been steadily rising, suggesting that Powell's market position confers pricing power.

At the very least, there's plenty of demand. Powell's first-quarter earnings results, reported earlier this month, topped Street estimates. The company's full-year earnings outlook was in line with what analysts were expecting, Reuters reports.

Good long-term performance and steady results in challenging economic times are traits of excellent, engaged management. Ask anyone that owns shares of Netflix (Nasdaq: NFLX  ) .

I think that's what we have here, too. Non-executive chairman and former CEO Tom Powell, son of company founder Bill Powell, still owns more than 20% of the company. Current chief executive Patrick McDonald has more than two decades of experience in the electrical business. I like this stock as a long-term play on rising energy costs.

How about you? Would you buy shares of Powell Industries 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.

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. Netflix is a Motley Fool Stock Advisor selection. Check out Tim's 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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