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

Conseco (NYSE:CNO)

***

0.96

(74.5%)

Bank of America (NYSE:BAC)

***

1.85

(58.6%)

Flextronics International (NASDAQ:FLEX)

***

1.54

(49.6%)

UTStarcom (NASDAQ:UTSI)

**

1.34

(85.5%)

Standard Pacific (NYSE:SPF)

*

1.80

(88.3%)

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 28 stocks that CAPS found hiding in the weeds, Washington, D.C.-area natural gas utility WGL Holdings (NYSE:WGL) intrigues me this week. The details:

Metric

WGL Holdings

Recent price

$31.90

CAPS stars (out of 5)

*****

Total ratings

60

Percent bulls

96.7%

Percent bears

3.3%

Price-to-book

1.48

ROE

11.22%

% Above 52-week low

12.7%

Sources: CAPS, Yahoo! Finance. Data current as of Jan. 28.

Utilities aren't typically my sort of investment, but WGL has been a consistent payer of dividends for over 100 years and its 4.60% yields as much as industry heavyweights such as TransCanada (NYSE:TRP).

That's important. Dividends are an underappreciated generator of long-term wealth, especially when investing in companies that have a history of hiking their payouts. WGL has raised its dividend an average of 2.4% a year over the past five.

I like that record, and as a result I'm willing to bet on WGL in my CAPS portfolio. How about you? Would you buy shares of WGL Holdings at today's prices? Let us know by signing up for CAPS today. It's 100% free to participate.

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