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 garbage-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

Tyco International (NYSE: TYC  )

***

1.97

(77.6%)

IAC (Nasdaq: IACI  )

***

1.46

(77.6%)

MeadWestvaco (NYSE: MWV  )

***

1.15

(43.9%)

Louisiana-Pacific (NYSE: LPX  )

**

1.98

(89.9%)

Pinnacle Entertainment (NYSE: PNK  )

*

1.64

(49.6%)

Sources: Motley Fool CAPS, Capital IQ.

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 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 121 stocks that CAPS found hiding in the weeds, it's Dr. Reddy's Laboratories (NYSE: RDY  ) , a generic drug manufacturer based in India, that intrigues me this week. The details:

Metric

Dr. Reddy's Laboratories

Recent price

$8.92

CAPS stars (5 max)

*****

Total ratings

356

Percent bulls

94.9%

Percent bears

5.1%

Price-to-book

1.31

ROE

10.2%

% Above 52-week low

22.7%

Sources: CAPS, Yahoo! Finance, Capital IQ. Data as of March 28, 2009.

"This generic drug manufacturer is based in India so they have relatively low overhead," wrote CAPS All-Star Trimalerus recently. Continuing:

Also they are located in the area of the world that has 70% of the world's population, which means lots of people needing medications. And being that India & China are relatively poor relative to Europe or the US they really like cheap generic drugs. I'll buy now that the price is about $8 and sell at $16 or so.

Perhaps, but you could also argue that it's a terrible time to buy. Another Indian generics expert, Ranbaxy, is accused of falsifying data in its applications with the Food and Drug Administration. That could have a chilling effect on all foreign producers, including Israel's Teva Pharmaceutical (Nasdaq: TEVA  ) and Dr. Reddy's, Foolish colleague Brian Orelli wrote recently.

Then again, it's often bad news that creates depressed prices. It's when prices go too low that value investors buy in bulk. Today, Dr. Reddy's trades for less than 17 times normalized earnings, well below historic norms. And perhaps low enough to get the garbage-divers sniffing around the shares.

But that's my take. I'm more interested in what you think. Would you buy shares of Dr. Reddy's Laboratories 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. Tyco is a current pick.

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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