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

(out of 5)

2004 Book Value

Subsequent Return

Centex (NYSE: CTX  )

*

1.92

(78.3%)

Pulte Homes (NYSE: PHM  )

*

1.65

(49.2%)

3Com (Nasdaq: COMS  )

**

1.90

(65.7%)

Stone Energy (NYSE: SGY  )

****

1.72

(81.0%)

Tech Data (Nasdaq: TECD  )

****

1.56

(51.9%)

Sources: Motley Fool CAPS, Capital IQ. Trailing 12-month P/B on 2/10/04. Return from 2/10/04 to 2/10/09.

Watch out!
How can you avoid value traps like these? My favorite method is borrowed from professor Aswath Damordaran, author of Investment Fables. In that book, 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, which also had returns on equity of 10% or more. Qualifiers were also trading no more than 25% above their 52-week low, leaving plenty of room for further gains. You can run this screen, though you should note that the results might be slightly different from what I got.

Of the 232 stocks that CAPS found hiding in the weeds, it's Motley Fool Hidden Gems pick Middleby (Nasdaq: MIDD  ) that intrigues me this week. The details:

Metric

Middleby

Recent price

$23.89

CAPS stars (out of 5)

****

Total ratings

2,934

Percent bulls

96.8%

Percent bears

3.2%

Bullish pitches

352 of 364

Price-to-book

1.94

ROE

33.8%

% Above 52-week low

9.8%

Sources: CAPS and Capital IQ, a division of Standard & Poor's.Data current as of Feb. 11, 2009.

Shares of the oven maker have fallen more than 58% over the past year. For CAPS investor bkwfool, that's an opportunity. Quoting from his late January pitch:

[Middleby] spent quite a while above my approximation of its intrinsic value. But now that it has cratered to $22/share, there is some margin of safety. Its biggest issues are that it took on debt for acquisitions and that the slow economy may make its customers pull back from purchasing new ovens. But its debt is at a low interest rate, and the cheaper restaurants to which it sells ovens are likely to be hurt less than the pricey ones. And its management has proven to be good for several years.

Debt is a legitimate concern -- looks what it's done to Sirius XM (Nasdaq: SIRI  ) . The differences here are (a) Middleby's debt doesn't threaten the company's existence as an independent entity and (b) management has an excellent record when it comes to capital allocation.

Indeed, Middleby's returns on invested capital have fallen below 20% exactly once on a trailing-12-month basis clear back to -- wait for it -- early 2004. There's no reason to believe management will develop a sudden case of stupid. Unless they do, today's earnings multiple -- just below seven -- seems unreasonably cheap.

Do you agree? Disagree? 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. There's no obligation to subscribe.

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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