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 instead, they're value traps -- stocks that deserve the multiples for which they trade, and punish the garbage-pickers 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

Chartered Semiconductor (Nasdaq: CHRT  )

*

1.75

(87.2%)

Micron Technology (NYSE: MU  )

**

1.68

(77.3%)

Hitachi (NYSE: HIT  )

**

1.28

(50.9%)

Human Genome Sciences (Nasdaq: HGSI  )

***

1.93

(83.2%)

Cooper Tire (NYSE: CTB  )

***

1.65

(75.4%)

Sources: Motley Fool CAPS, Capital IQ (a division of Standard & Poor's).

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 when you're in the weeds
Our 125,000-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. These stocks were also trading no more than 25% above their 52-week low, leaving plenty of room for further gains.

Of the 198 stocks that CAPS found hiding in the weeds, recent Motley Fool Inside Value pick American Express (NYSE: AXP  ) intrigues me this week. The details:

Metric

American Express

Recent price

$17.01

CAPS stars (5 max)

***

Total ratings

2,718

Percent bulls

90.1%

Percent bears

9.9%

Price-to-book

1.58

ROE

26.3%

% Above 52-week low

4.2%

Sources: Motley Fool CAPS, Yahoo! Finance, Capital IQ.
Note: Data current as of Jan. 20, 2009.

I'm most impressed by how cheap American Express has become. At less than six times earnings, AmEx is priced as if there's no growth left in its business.

There's certainly reason to be concerned. Personal consumption -- read: consumer spending -- fell 3.8% in the third quarter of 2008, and it appears to have dropped at least another 3% in Q4, Fortune reports. Card issuers such as AmEx and Inside Value peer Discover Financial Services (NYSE: DFS  ) take a hit when consumers get nervous; fewer transactions equals less fee income.

So why should investors buy now? American Express has loyal customers and smart backing in Warren Buffett, who's held shares for years. The U.S. Treasury also recently approved AmEx's application to participate in the Troubled Asset Relief Program, which should backstop its balance sheet.

Adds fellow Fool and CAPS All-Star Stan Huber, known here as TMFPlatoish:

American Express is an iconic brand -- Don't leave home without it! If a credit card can gain brand loyalty, this is the one. It carries a certain amount of status I suppose. At any rate, it is kind of unique in that it controls all aspects of the card transactions. It also has a generally more qualified customer base and should see fewer defaults than many less discerning card issuers. I see this stock recovering some in the near term and then return to its previous growth rates as we pull out of the economic tailspin. Might be early, but not by too much.

Agreed, but I'm more interested to know what you think. Is American Express the bargain it appears to be, or a value trap waiting to snap? 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.

American Express and Discover Financial Services are Inside Value picks. The Motley Fool owns shares of American Express.

Fool contributor Tim Beyers is also a member of the Rule Breakers team. Tim didn't own shares in any of the stocks 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 (3) | Recommend This Article (10)

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 January 20, 2009, at 7:29 PM, jsoc wrote:

    I like AXP, but the indirect mention of DFS is dangerous. Discover Card got its success from offering higher than typical credit limits and its typical card holder has a lower credit rating than AXP and card issuers.

  • Report this Comment On January 21, 2009, at 10:19 AM, cayrel wrote:

    I like Amex ,too.It has a sound understandable model and a good diverse business...corporate as well as consumer( cards and travel).In normal circumstances, when the consumer business is weak, the corporate makes up for it, and vice versa.Of course , these are not normal times, and the share price has rightly been hit, but to my mind,far too hard and well below fair value.I think once we can see the wood for the trees,we'll see Amex storm back.I won't say the management has made no mistakes, but I believe they do have a strong leadership team who will see Amex thru this .

  • Report this Comment On January 21, 2009, at 11:15 AM, 10qdetective wrote:

    HGS had a working capital shortfall of $57.0 million at September 30, 2008, but the company expects 2009 net cash burn of less than $25 million, compared with approximately $245 million in 2008. Although revenue for the next two years will likely be limited to ABthrax sales, the company could receive milestone payments and/or R&D reimbursement(s) under terms of collaborative and licensing agreements currently in place with Novartis and GlaxoSmithKline:

    http://blogs.bnet.com/secdocuments/?p=229

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