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
|
2005 Price-to-Book
|
Price Change
|
|---|---|---|---|
|
Dynegy |
**** |
0.81 |
(63.1%) |
|
STMicroelectronics |
*** |
1.70 |
(56.4%) |
|
KeyCorp |
** |
1.94 |
(79.9%) |
|
Redwood Trust |
** |
1.48 |
(76.3%) |
|
Webster Financial |
** |
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
|
Metric |
|
|---|---|
|
Recent price |
$28.67 |
|
CAPS stars (5 max) |
**** |
|
Total ratings |
128 |
|
Percent bulls |
89.8% |
|
Percent bears |
10.2% |
|
1.28 |
|
|
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
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:
- Take a look at our last litter of cheapskates.
- Why is Wall Street still playing an insane poker game?
- These might be the best dividend stocks of the decade.
