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 instead, they're value traps -- stocks that deserve the multiples for which they trade, and punish the garbage-grabbers 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

Pep Boys - Manny, Moe & Jack (NYSE: PBY  )

***

1.91

(68.1%)

Blockbuster (NYSE: BBI  )

*

0.84

(93.4%)

Furniture Brands (NYSE: FBN  )

*

1.32

(82.3%)

D.R. Horton (NYSE: DHI  )

*

1.97

(56.2%)

Dillard's (NYSE: DDS  )

*

0.73

(51.5%)

Sources: Motley Fool CAPS, Capital IQ.

Watch out!
How can you avoid value traps like these? My favorite method is borrowed from professor Aswath 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 135,000-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 41 stocks that CAPS found hiding in the weeds, Pharmaceutical Product Development (Nasdaq: PPDI  ) intrigues me most this week:

Metric

Pharmaceutical Product Development

Recent price

$20.48

CAPS stars (5 max)

*****

Total ratings

533

Percent bulls

98.7%

Percent bears

1.3%

Price-to-book

1.98

ROE

15.7%

% Above 52-week low

14.0%

Sources: CAPS, Yahoo! Finance.
Data current as of June 5, 2009.

This Motley Fool Stock Advisor selection has suffered from mixed blessings recently. The bad news first: Yesterday, PPD said that it could need several more years to win European approval for a diabetes treatment called alogliptin.

The good news: Last week, PPD's board voted to increase the company's dividend by 20%. The stock yields 2.90% as of this writing.

But the All-Star investors in our CAPS community like the stock for reasons beyond its promising dividend. As CAPS investor A6EIntruder wrote earlier this week:

Once upon a time I worked for a CRO [contract research organization] called Quintiles, which has since gone back to being a private company--and remains the biggest CRO in the field today.

I was on their contract sales side, so I can't claim any clinical experience. However, even at the time (this is over a decade ago), I believed that the proposition for future CRO growth and success was a no-brainer. Drug companies get what they want, the CRO gets its share of the pie. I believe it is insulated to a greater degree than the big pharma which pays its bills from the shocks of health care reform ballyhoo since the bulk of their business is research.

PPD also trades for a lower multiple to earnings than competitors such as Covance (NYSE: CVD  ) , not to mention the industry at large. That's usually a good sign.

But that's also just my take. Would you buy shares of Pharmaceutical Product Development 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 Inside Value service, which spotlights stocks that Mr. Market has put on sale. Pharmaceutical Product Development is a Stock Advisor selection. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Tim Beyers is also a member of the Rule Breakers stock-picking team. He didn't own shares in any of the companies 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.


Read/Post Comments (1) | Recommend This Article (8)

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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 June 07, 2009, at 2:56 PM, greenwave3 wrote:

    I agree. PPDI is a buy. The ever-increasing dividend is yet another reason to hang around and let this company grow into a fatter valuation as big pharma struggles to fill expiring drug pipelines.

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