Money Matters - Simplified

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)

2004 Book Value

Return Since

Modine Manufacturing (NYSE: MOD)

***

1.79

(71.6%)

Chiquita Brands (NYSE: CQB)

***

1.00

(40.5%)

Advanced Micro Devices (NYSE: AMD)

**

1.63

(68.7%)

FuelCell Energy (Nasdaq: FCEL)

**

1.76

(53.1%)

Hovnanian Enterprises (NYSE: HOV)

*

1.88

(89.6%)

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, 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.

A machete for when you're in the weeds

Our 135,000-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 23 stocks that CAPS found hiding in the weeds, Consolidated Edison (NYSE: ED) intrigues me this week. The details:

Metric

Consolidated Edison

Recent price

$39.10

CAPS stars (5 max)

****

Total ratings

549

Percent bulls

96.0%

Percent bears

4.0%

Price-to-book

1.10

ROE

11.1%

% Above 52-week low

19.8%

Sources: CAPS, Yahoo! Finance.
Data current as of July 27, 2009.

Ask the Fools who like this New York utility for their portfolios, and chances are they'll praise it as a safe dividend play.

"[T]he company has raised dividends consistently for 35 years -- including February 2009," wrote CAPS investor helicopterfool in February:

Moreover, the stable nature of regulated power
distribution have helped ConEd stockholders beat the broad market by
more than 30 percentage points over the past year. It hasn't traded
this low since March, 2005. It won't necessarily go to the moon, but it
will beat the S & P.

Consistent dividend payers
have a way of doing that, especially stocks whose yields far outpace
the average yield of the broader market. Consolidated Edison yields an
even 6% as of this writing.

But dividends are also no guarantee of success. Look at the bankers. Bank of America (NYSE: BAC) was a proven payer before the financial crisis. Do you trust ConEd's yield? Would you buy shares of Consolidated Edison at today's prices? Let us know by signing up for CAPS today. It's 100% free to participate.

 

Copyright 2009 by United Press International.