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). 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).

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.

We believe the job cuts, designed to save the company $160 million a year in expenses, and UTStarcom's early success in selling into new markets -- such as India, where UTStarcom's sales were up 37% sequentially in the second quarter -- will be enough to put a floor under the current valuation. And continued strength in the global handset market and UTStarcom's large presence in emerging markets like China and India should drive upside from here. A good quarter or two should put UTStarcom back into the double-digits.

We also like the prospects of market-maker and asset-management company Knight Capital ( NITE). Through its trading business, Knight facilitates buy and sell orders for customers and its proprietary trading account that uses in-house money to make bets on the stock market.

Its asset-management business is dominated by its subsidiary, $3.4 billion hedge fund Deephaven, which allows Knight to capitalize on the lucrative fee structure that the hedge fund business affords. At just $8.43, shares trade right at their book value.

In the June quarter, Knight delivered total revenue of $111 million and lost 5 cents a share. This marked a 21% year-over-year decline in total revenue, due in large part to a $34 million decline in trading revenue. The slowdown in trading revenue has been a big red mark on the company's results over the last year as industry pricing for trading has come down and pressured sales and margins.

Although the trading business may not be near an imminent rebound, Knight has about $830 million in cash and investments, and virtually no debt. And since the beginning of the year, Knight has generated $138 million in cash from operating activities. So the stock is trading at less than its cash value, which we believe more than discounts the weakness in its trading business. But it is our view that the current price-to-book valuation completely ignores upside potential in the company's asset-management business, creating a good entry point for readers.

For example, consider the earnings potential from a strong equity market. Not only does Knight have more than $200 million of its own capital invested in Deephaven, it also gets a 50/50 cut of the 20% management take on the fund's profit. It also collects a management fee on the assets under management. Of course, a negative equity market would affect earnings to the downside, but the stock market has averaged a roughly 10% return for investors over the last 100 years, so betting against Knight in anticipation of a negative equity market wouldn't be prudent.

As originally published, this story contained an error. Please see Corrections and Clarifications.

The Stocks Under $10 team is William Gabrielski and David Peltier. Gabrielski is a research associate at TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Gabrielski welcomes your feedback and invites you to send your comments to william.gabrielski@thestreet.com.

Interested in more writings from William Gabrielski? Check out Stocks Under $10. For more information, click here.

Peltier is a research associate at TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Peltier welcomes your feedback and invites you to send your comments to david.peltier@thestreet.com.

More from Investing

Danica Patrick's Final Race at 2018 Indianapolis 500: What She Thinks About Cars

Danica Patrick's Final Race at 2018 Indianapolis 500: What She Thinks About Cars

Why The FANG Stocks' Dominance May Not Be So Bad For The Market

Why The FANG Stocks' Dominance May Not Be So Bad For The Market

At End of May, Investors Signalling They May Stay Away

At End of May, Investors Signalling They May Stay Away

Inside Carnival's Mind Blowing New Horizon Cruise Ship (Video)

Inside Carnival's Mind Blowing New Horizon Cruise Ship (Video)

Neel Kashkari: The Heart of Our Financial System Is More Radioactive Than Ever

Neel Kashkari: The Heart of Our Financial System Is More Radioactive Than Ever