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:


CAPS Rating (out of 5)

2004 Price-to-Book Ratio

Return Since

Dynegy (NYSE:DYN)




KeyCorp (NYSE:KEY)








Entercom Communications (NYSE:ETM)








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:


Knight Capital Group

Recent price


CAPS rating (out of 5)


Total ratings


Percent bulls


Percent bears






% Above 52-week low


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.

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