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 they're actually value traps -- stocks that deserve the multiples for which they trade, and punish the trashpickers who buy them.

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

Company

CAPS Rating

(5 max)

2004 Book Value

Return Since

Vishay Intertechnology (NYSE: VSH  )

***

1.29

(89.1%)

Chiquita Brands (NYSE: CQB  )

***

1.11

(76.9%)

LSI (NYSE: LSI  )

***

1.81

(74.8%)

Tellabs (Nasdaq: TLAB  )

***

1.73

(59.5%)

Stewart Information Services (NYSE: STC  )

***

1.03

(58.5%)

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 437 stocks that CAPS found hiding in the weeds, it's Adobe Systems (Nasdaq: ADBE  ) that intrigues me this week. The details:

Metric

Adobe Systems

Recent price

$16.78

CAPS stars (5 max)

*****

Total ratings

1,620

Percent bulls

96%

Percent bears

4%

Price-to-book

1.99

ROE

19.8%

% Above 52-week low

15%

Sources: CAPS, Yahoo! Finance, Capital IQ. Note: Data current as of March 10.

My Foolish colleague Rich Smith, known here as TMFDitty, finds that Adobe's valuation is too attractive to resist. Quoting from his pitch from January:

Bargains like this one come along only a few times in a decade. Bursting with cash and generating massive free cash flow, Adobe currently sells for an EV/FCF ratio of less than 7.5. Analysts who predict the firm will grow its profits at 16% per year over the long-term would have to be off by a factor of 50% in order to make this stock anything more than fairly priced.

Those numbers haven't changed much since. Nor have Adobe's returns on equity and capital -- both have been rising since 2006, a good sign in light of increased competition from Microsoft's (Nasdaq: MSFT  ) Silverlight in enabling rich media.

But that's my take. What's yours? Would you buy Adobe 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 Mr. Market has put on sale. Microsoft is a recommendation of the service.

Stewart Information Services is a Motley Fool Hidden Gems recommendation.

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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