Don't Miss This Cheap Stock

Cheap stocks can get cheaper. They often do.

Unfortunately, "cheap" is a relative term. Precious few stocks trading 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

MGIC Investment (NYSE: MTG  )

*

1.78

(97.1%)

Apartment Investment & Mgmt. (NYSE: AIV  )

*

1.54

(41.9%)

Hearst-Argyle Television (NYSE: HTV  )

**

1.62

(84.9%)

Sycamore Networks (Nasdaq: SCMR  )

***

1.59

(57.2%)

China Eastern Airlines (NYSE: CEA  )

**

1.49

(25.6%)

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 Damordaran, 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 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. Qualifiers were also trading no more than 25% above their 52-week low, leaving plenty of room for further gains.

Of the 262 stocks that CAPS found hiding in the weeds, it's Motley Fool Rule Breakers recommendation Take-Two Interactive (Nasdaq: TTWO  ) that intrigues me this week. The details:

Metric

Take-Two Interactive

Recent price

$7.44

CAPS stars (5 max)

****

Total ratings

899

Percent bulls

91.8%

Price-to-book

1.35

ROE

17.9%

% Above 52-week low

21.5%

Sources: CAPS, Yahoo! Finance, Capital IQ.
Data current as of Jan. 26, 2009.

Rule Breakers teammate Rick Munarriz argued convincingly last week in favor of Take-Two in his monthly list of five attractive stocks under $10:

Take-Two earned $2.08 a share in fiscal 2008 (which ended in October) but is slated to turn a profit of just $0.11 a share this year. Its chief operating officer resigned last week after just a few months on the job. However, analysts see earnings jumping to $1.00 next fiscal year, giving the stock an attractive valuation based on that year's proposed multiples. It also gives Take-Two time to pull another hit or two out of its hat.

"Time" could be the key word there. A very public, months-long tete-a-tete with Electronic Arts (Nasdaq: ERTS  ) likely caused distractions that Take-Two can ill afford -- especially in a what-have-you-built-for-me-lately business like video game publishing.

But with the stock trading for just seven times next year's earnings, the risks of Take-Two being a value trap seem muted.

Do you agree? Disagree? Let us know by signing up for CAPS today. It's 100% free to participate. In the meantime, I'll 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. There's no obligation to subscribe.

Take-Two Interactive is a Rule Breakers recommendation. Electronic Arts is a Stock Advisor selection.

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.


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