Navigating Book-Value Traps

Investors are often drawn to the under-$10 space in search of cheap stocks or stocks that trade at a discount to their book values. But although there are plenty of stocks priced below $10 a share, there are also land-mine stocks that masquerade as good value plays. These stocks are nothing more than value traps, or stocks that appear relatively inexpensive but should be avoided because the fundamentals are deteriorating.

We ran a screen for stocks trading at less than book value, and discovered two oft-shunned companies that we believe are worthy of a value investor's money. We aren't taking a position for the model portfolio because we are nearly fully invested and would have to make a sale of one of our existing positions. First, for the more speculative value hunter, we have broadband access play UTStarcom (UTSI - Cramer's Take - Stockpickr). About 80% of UTStarcom's sales are generated from cellular equipment sales into China. Once a darling of momentum-oriented hedge funds, UTStarcom shares now change hands at $8.08, or about 16% of their 2003 highs of nearly $50 a share. With most of the growth investors now out of the stock, we believe shares represent a compelling value at just 0.69 times book value.

UTStarcom is gaining momentum, but this has yet to be discovered by the market. On July 11, UTStarcom announced a $185 million contract win from China Telecom for network equipment and handsets -- UTStarcom owns handset maker Audiovox -- that adds to UTStarcom's order backlog of more than $900 million. The company should meet the Street's 2006 earnings forecast of 45 cents a share, given the China Telecom deal and the potential for an upswing in emerging-market cellular activity. UTStarcom's shares are trading at just 17 times earnings estimates, which is a relative discount to other wireless plays such as Motorola (MOT - Cramer's Take - Stockpickr).

Of course, UTStarcom shares aren't trading below book value by chance alone. In July of 2004, UTStarcom missed third-quarter earnings expectations due to soft pricing in the Chinese market. Management said it would improve results by expanding into other markets, such as India.

But management's plan didn't pan out as expected, and in January, the company said it would miss the Street's fourth-quarter earnings forecast of a penny loss when it guided for a loss of 40 cents to 45 cents a share. The company ended up hitting the lower end of this target with a 45-cent loss. Then, in May, UTStarcom said its first-quarter profit would come in below expectations, forcing the company to slash 1,400 jobs to reign in costs in the face of continued end-market weakness.