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
|
2004 Price-to-Book
|
Return Since |
---|---|---|---|
Allied Capital |
** |
1.68 |
(76.4%) |
Weyerhaeuser |
** |
1.87 |
(34.4%) |
Beazer Homes |
* |
1.21 |
(82.8%) |
Media General |
* |
1.17 |
(80.3%) |
Pulte Homes |
* |
1.69 |
(57.3%) |
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 140,000-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 22 stocks that CAPS found hiding in the weeds, Verizon
Metric |
|
---|---|
Recent price |
$29.16 |
CAPS stars (5 max) |
**** |
Total ratings |
3,378 |
Percent bulls |
94.3% |
Percent bears |
5.7% |
1.96 |
|
21.7% |
|
% Above 52-week low |
26.4% |
Sources: CAPS, Yahoo! Finance. Data current as of Oct. 8.
Verizon's wireless group is intriguing because it's emphasizing deals over exclusive relationships. I'll understand if that doesn't seem wise. The iPhone has been a profit booster for AT&T
Verizon, by contrast, has broadly committed to the Android mobile operating system and expects to sign deals with several handset manufacturers in the coming weeks. AT&T apparently sees some merit in this move. According to The Wall Street Journal, this week it signed a deal with Dell
"They're finally getting some decent smart phones! Verizon has spent a lot of $$developing their network and not enough on bringing in products that people actually want to use," wrote CAPS All-Star PlasmonPolariton earlier this week. "With the new smart phones ... I think that will change and their customers will benefit greatly from their huge network."
Agreed, but that's also just my take. Would you buy shares of Verizon at today's prices? Let us know by signing up for CAPS today. It's 100% free to participate.
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