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 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

Kindred Healthcare (NYSE: KND  )

****

1.47

(53.3%)

Imation (NYSE: IMN  )

***

1.76

(65.9%)

Freddie Mac (NYSE: FRE  )

**

1.49

(98.9%)

Sanmina-SCI (Nasdaq: SANM  )

*

1.69

(97.5%)

XL Capital (NYSE: XL  )

*

1.40

(96%)

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. (You can run the screen, too; the data is updated in real time.)

Of the 64 stocks that CAPS found hiding in the weeds, Cardinal Health (NYSE: CAH  ) intrigues me this week. Its details:

Metric

Cardinal Health

Recent price

$35.18

CAPS stars (5 max)

****

Total ratings

325

Percent bulls

90.2%

Percent bears

9.8%

Price-to-book

1.46

ROE

14.2%

% Above 52-week low

26.7%

Sources: CAPS, Yahoo! Finance.
Data current as of May 26, 2009.

Cardinal makes and distributes medical supplies; unfortunately, it caught the attention of the Internal Revenue Service after allegedly engaging in some dubious accounting practices. Earlier this month, the IRS told the company that it would challenging $178.9 million in tax shelters that Cardinal claimed from 2001 to 2005, according to The Wall Street Journal.

Mix in promises of a heavy dose of federal health-care reform, and Cardinal's salad days could be over. But management isn't willing to yield. Instead, executives are rallying employees via a "value-for-value" stock options exchange program that would reset prices for those who hold options with strike prices lingering above the stock's 52-week high.

If that sounds like Google's (Nasdaq: GOOG  ) evil options swap, think again. Cardinal is allowing employees to trade down, taking fewer options at more favorable strike prices. Investors shouldn't need to eat any additional compensation expense on employees' behalf.

Will the options exchange program rally beleaguered employees to fight the IRS? Will the stock rebound as a result? Cardinal Health trades for slightly more than 10.5 times trailing earnings and 9.5 times forward earnings -- roughly in line with Wall Street's long-term earnings projections. Most CAPS investors seem to think that's fair.

"I believe that no matter what Obama does with health care, this stock is going to be a winner," wrote CAPS investor Kowboy01 in January. "Drug and insurance stocks carry risk because of the eventual threat of price controls and regulation that a nationalized health care system may bring. The products and services that [Cardinal] offers is a layer below this, so I think it will be insulated from such controls."

Agreed, but that's also just my take. Would you buy shares of Cardinal Health at today's prices? Let us know by signing up for CAPS today. It's 100% free to participate.

More bargain-basement Foolishness:

Want further guidance? Get 30 days of free access to the Fool's Motley Fool Inside Value service, which spotlights stocks that Mr. Market has put on sale. Google is a Rule Breakers recommendation.

Fool contributor Tim Beyers is also a member of the Rule Breakers stock-picking team. He had stock and options positions in Google 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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