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 Price-to-Book Ratio

Return Since

Finisar (Nasdaq: FNSR  )

****

1.66

(60.5%)

Vishay Intertechnology (NYSE: VSH  )

***

0.97

(54.1%)

Pep Boys - Manny, Moe & Jack (NYSE: PBY  )

***

1.61

(46.5%)

Micron Technology (NYSE: MU  )

**

1.50

(54.5%)

O'Charley's

*

1.26

(39.0%)

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, 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 135,000-member-strong Motley Fool CAPS community 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 32 stocks that CAPS found hiding in the weeds, Orbital Sciences (NYSE: ORB  ) intrigues me this week. The details:

Metric

Orbital Sciences

Recent price

$13.53

CAPS stars (out of 5)

****

Total ratings

320

Percent bulls

97.5%

Percent bears

2.5%

Price-to-book

1.63

ROE

8.7%

% above 52-week low

16.6%

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

Orbital's growth hasn't exactly crashed. Call it a slow decay. Second-quarter revenue dropped 10%, and earnings fell 12%. But thanks to NASA, those numbers could soon fade from red to black.

A subcommittee of the Human Space Flight Review panel recently told NASA's higher-ups that the space agency would do better to outsource travel to and from the International Space Station, Reuters reports. Orbital Sciences' primary experience is with satellite payloads, but any sort of outsourced "taxi" service would benefit contractors with payload and launch experience. Orbital could make that list, as could Boeing (NYSE: BA  ) and Lockheed Martin (NYSE: LMT  ) .

Plus, at today's levels, the stock is cheap. "Based on CEO David Thompson's latest estimate, we're probably looking at some $55 million in free cash flow generated this year," my Foolish colleague Rich Smith wrote recently. "Assuming [Thompson's] right, the stock now trades for a mere 10 times free cash flow to enterprise value. Most analysts think the company can grow its profits at nearly 15% per year over the next five years."

Not a bad price for a turnaround story in the making. Then again, that's just my take. Would you buy shares of Orbital Sciences at today's prices? Let us know by signing up for CAPS today. It's 100% free to participate.

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Fool contributor Tim Beyers is also a member of the Motley Fool Rule Breakers stock-picking team. Orbital Sciences is among their recommendations. Tim didn't own shares in any of the companies mentioned in this article at the time of publication. Check out his portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. The Motley Fool is also on Twitter as @TheMotleyFool. Its disclosure policy is a bargain at any price.


Read/Post Comments (2) | Recommend This Article (18)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 01, 2009, at 11:15 PM, apc76 wrote:

    This is a bunch of BS...

    Couple weeks ago they write an article and the stock gets cut almost in half. NOW it's "cheap".

    Disappointed... Make up your mind.

    I wonder "who" is manipulating the market. This should be criminal...

  • Report this Comment On August 03, 2009, at 3:14 PM, plange01 wrote:

    you can buy a big name stock like boeing at a 70% discount!..this stock should be selling over 60 now and run right through the 80's when the dreamliner comes out .then move over its $107 price from a little over a year ago....

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