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 grabage-divers who buy them.

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

Company

CAPS Stars (5 max)

2004 Book Value

Return Since

MGIC Investment (NYSE: MTG  )

*

1.73

(96.5%)

KB Home (NYSE: KBH  )

*

1.67

(67.7%)

Jones Apparel (NYSE: JNY  )

**

1.97

(92.1%)

Adaptec (Nasdaq: ADPT  )

**

1.65

(75.3%)

Analogic (Nasdaq: ALOG  )

**

1.59

(30.5%)

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. The stocks also had to be trading no more than 25% above their 52-week low, a margin that leaves plenty of room for further gains.

Of the 366 stocks that CAPS found hiding in the weeds, it's Stock Advisor selection Atwood Oceanics (NYSE: ATW  ) that intrigues me this week. The details:

Metric

Atwood Oceanics

Recent price

$14.49

CAPS stars (5 max)

*****

Total ratings

1,778

Percent bulls

99.2%

Percent bears

0.8%

Price-to-book

1.23

ROE

32.3%

% Above 52-week low

15%

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

A backlog of commitments for its oil rigs makes Atwood highly attractive to CAPS All-Star MLGtrader. Taking a portion from last week's pitch:

Oil demand and prices have been deteriorating away in recent months as the recession worsens. Inventories are piling up and companies are trying to stop pumping because the price is so low. This all sounds like horrible news for the companies who rent to the people who drill and it is.

The catch is that these companies all have lease contracts on their rigs usually spanning a few years. This is great news for the companies that have contracts locked up far into the future because they can just rake in the same profits [as] when there was peak oil for a few more quarters. [Emphasis added.]

That could be why Atwood reported that its first-quarter earnings doubled earlier this month. Revenue rose 49%. It's enough to make me wonder whether this is a growth-meets-value story in the making.

To be fair, fellow CAPS All-Star ValuePEG, citing a bulkier backlog, prefers Transocean (NYSE: RIG  ) as the "safer" stock between these two. But this CAPS member concurs with the essentials of MLGtrader's thesis. "I do agree that the analysts estimates of earnings growth do not make sense looking at [Atwood's] contract [backlog]," this Fool writes in a reply.

What about you? Would you buy Atwood Oceanics 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. 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. Atwood Oceanics is a Motley Fool Stock Advisor pick. The Motley Fool is also on Twitter as @TheMotleyFool. Its disclosure policy is a bargain at any price.


Read/Post Comments (2) | Recommend This Article (16)

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 February 26, 2009, at 5:51 PM, CashonDelivery wrote:

    RIG and ATW are both great. I own both. I would agree that RIG is certainly safer than ATW, but I also belive that ATW has greater upside, especially when they get employment for the Southern Cross.

    Good luck to all.

  • Report this Comment On February 27, 2009, at 7:43 AM, FoolSolo wrote:

    Using this approach to screen, I came up with a different list of stocks. I started with P/B < 2, ROE > 15% and Price = 0-10% > 52WK LOW, but then I also added the following:

    DEBT/EQ < 20%,

    CURR RATIO > 1,

    QUICK RATIO > 1,

    EPS GROWTH (TTM) > 10%,

    EPS GROWTH (Past 5 Yrs) > 10%,

    SALES GROWTH (Past 5 Yrs) > 10%,

    NET PROFIT MARGIN > 10%,

    AVG. VOLUME > 200K,

    MKT CAP > $300MM,

    My screen caught 24 companies:

    RDC, CRDN, PDE, YZC, ESV, PKX, GLW, SIGM, HLIT, NE, EBAY, GIGM, EZPW, ZMH, DRQ, PMCS, FRX, GRMN, IIVI, PCP, ARD, MCRS, CVD, GES

    This screen is a little more defensive, and looks for record of growth, good liquidty in cash and in the stock. I was a little surprised that ATW and RIG were not on this list.

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