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 Dumpster-divers who buy them.

But don't take my word for it. Here are five "cheap" stocks that trapped bargain-hunting prey:

Company

CAPS Stars (5 max)

2004 Book Value

Return Since

Coherent (Nasdaq: COHR  )

**

1.38

(32.2%)

MFA Financial (NYSE: MFA  )

**

1.21

(11.2%)

Centex (NYSE: CTX  )

*

1.90

(79.6%)

Pulte Homes (NYSE: PHM  )

*

1.77

(56.5%)

Jo-Ann Stores (NYSE: JAS  )

*

1.82

(41.9%)

Sources: Motley Fool CAPS, Capital IQ.

Watch out!
How can you avoid value traps like these? My favorite method is borrowed from professor Aswath Damodaran, author of Investment Fables. In it, 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 130,000-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 74 stocks that CAPS found hiding in the weeds, it's wannabe oil emperor Chevron (NYSE: CVX  ) that intrigues me this week. The details:

Metric

Chevron

Recent price

$66.58

CAPS stars (5 max)

****

Total ratings

3,064

Percent bulls

95.2%

Percent bears

4.8%

Price-to-book

1.54

ROE

27.6%

% Above 52-week low

19.9%

Sources: CAPS, Yahoo! Finance. Data current as of April 14, 2009.

Interestingly, it's Iraq that has CAPS bulls like mtinvest running toward Chevron. Quoting from a pitch this investor posted last week:

I would rather invest in Gazprom of Russia, PetroChina (subsidiary of state owned CNPC), Petronas of Malaysia, [Petrobras (NYSE: PBR  ) ] of Brazil that keep increasing their reserves. But now that Chevron and Total are about to be in control of the Iraqi oil fields, they seem interesting.

Now does that strike you as a stock that should be trading for less than the industry average? Not me. And yet, at 5.7 times earnings, Chevron is priced as if it's a member of Team Energy's junior varsity. Crazy.

But that's my take. Would you buy shares of Chevron at today's prices? Let us know by signing up for CAPS today. It's 100% free to participate. See you back here next week with more bargain basement Foolishness.

Want further guidance? Get 30 days of free access to the Fool's Inside Value service, which spotlights stocks that Mr. Market has put on sale. Petrobras is an Income Investor recommendation.

Fool contributor Tim Beyers is also a member of the Rule Breakers team. He 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.


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