Don't Get Caught When This Value Trap Snaps

Cheap stocks can get cheaper. They often do.

But don't get carried away. You should study what cheap really means. A low price-to-earnings ratio? Not necessarily; current earnings may be either overstated or unsustainable. A low price-to-book value? Sure, if the assets held by the company you're buying are fairly valued or, better yet, understated.

Too many investors fail to dig deeper. They accept the shorthand and get caught in a value trap -- a stock that looks cheap at first but isn't. It's a nightmare that haunts far too many, far too often. But don't take my word for it. Here are five "cheap" stocks that trapped bargain-hunting prey:

Sources: Motley Fool CAPS and Capital IQ, a division of Standard & Poor's.

Watch out!
How can you avoid value traps like these? My favorite method is borrowed from professor Aswath Damordaran, author of Investment Fables. In it, he 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.

Conversely, find a low price-to-book firm that either produces minimal returns on equity, or that destroys equity, and you've found a stock that very likely deserves the multiple that Mr. Market has assigned to it. A value trap in the making, if you will.

A machete for when you're in the weeds
Finding these fakers isn't difficult thanks to our 125,000-member Motley Fool CAPS database. I ran a screen for low-rated stocks trading for less than twice book value and whose returns on equity were 5% or less. In addition, they had to be trading at least 40% above their 52-week low, leaving plenty of room for a fall.

Of the 124 stocks that CAPS found lurking in the weeds, it's Alaska Air Group (NYSE:ALK) that concerns me this week.

Data current as of Jan. 6, 2009.

Most troubling is how far Alaska Air has moved in just a few months. CAPS All-Star ValueMrk spotted a bargain in the making in late November:

Best Managed Airline in the business. Alaska's management is creating great value and has taken precautionary steps to hedge fuel, reduce waste, and get efficiency. [Alaska Air] - has great cash position outperformed its peer group and it has given the index a run for its money! Recently, announced a partnership with Delta on westcoast.

I'd give Southwest (NYSE:LUV) the title of "best managed," but our Fool's other points are worth considering. At the very least, congratulations are in order for a gutsy outperform call that's beaten the market by more than 40%.

Yet I wonder what's next. How does Alaska Air go higher when December traffic fell more than 5% and its planes flew at more than 80% full? Alaska certainly could outperform, but I don't sense a long-term advantage that prevents this cyclical business from suffering another oil-induced cyclical downturn. Negative equity returns don't instill confidence, either.

But that's my take. I'm more interested to know what you think. Is Alaska Air a value trap at today's prices? Let us know by signing up for CAPS today. It's 100% free to participate.

See you back here next week with another value trap that's about to snap. Fool on!

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