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-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 (out of 5)

2004 Price-to-Book Value

Return Since

Dynegy (NYSE: DYN  )

****

0.79

(51.2%)

TRW Automotive (NYSE: TRW  )

**

1.84

(52.3%)

THQ (Nasdaq: THQI  )

**

1.96

(50.4%)

Standard Pacific (NYSE: SPF  )

*

1.56

(91.6%)

Superior Industries

*

1.50

(50.1%)

Sources: Motley Fool CAPS, Capital IQ, Yahoo! Finance.

Watch out!
How can you avoid value traps like these? My favorite method is borrowed from professor Aswath Damordaran, author of Investment Fables. In that book, 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 53 stocks that CAPS found hiding in the weeds, The9 (Nasdaq: NCTY  ) intrigues me this week. The details:

Metric

The9

Recent price

$10.52

CAPS stars (out of 5)

***

Total ratings

994

Percent bulls

96.4%

Percent bears

3.6%

Price-to-book

0.66

ROE

11.6%

% Above 52-week low

22%

Sources: CAPS, Yahoo! Finance.
Data current as of June 25, 2009.

That's not an easy call. Activision Blizzard (Nasdaq: ATVI  ) pulled The9's license to distribute its ultra-popular World of Warcraft (WoW) multiplayer online game in China earlier this month. As a result, revenue and cash flow are likely to plummet in the short term, creating significant losses. The9's latest available 20-F annual report -- from June 2008 -- corroborates this assertion:

In the years ended December 31, 2006 and 2007, the total revenue attributable to the operations of the WoW game and WoW related product sales were RMB1,028,989,688, which represented approximately 99% total revenue, and RMB1,243,630,836, which represented approximately 92% total revenue, respectively.

So the company is doomed, right? Not so fast. I certainly wouldn't bet big on this business; there are too many unknowns. But we do know that at present levels, The9 trades for less than the cash on its books: more than $320 million, as of December.

We also know that Electronic Arts (Nasdaq: ERTS  ) owns a 15% stake in The9. You think executives there will just stand by and watch their $167 million wither away? I don't.

Oppenheimer is probably right: The9 will likely suffer losses and burn through some of its cash hoard as it pushes to launch and market new games. But the company needed just $37 million of capital investment in 2007, and much less than that in years prior. Bankruptcy isn't imminent.

My guess is that The9 has at least a two-year cash cushion. Mix in the possibility of EA stepping in as a white knight, and a medium-term bounce in the stock price seems likely. But that's just my take. What would you do? Would you buy shares of The9 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. Activision Blizzard and Electronic Arts are Motley Fool Stock Advisor selections. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Tim Beyers is also a member of the Motley Fool 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 (4) | Recommend This Article (1)

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 June 27, 2009, at 10:18 AM, moneyman2009 wrote:

    What a worthless article. The return on your investment for TRW in the past 4 months was 500% - thats 5X your initial investment (1.6 to 10.1, current 9). If your not reading this thing to make money...why read it. The economy in the last year is way different that reaching back to 2004 to try and make a story. Where's the analysis for the short term impact to auto stocks that have been BK'ed and unburdened by debt/consolidated/and are rebounding.

  • Report this Comment On June 28, 2009, at 12:40 PM, Varchild2008 wrote:

    The9 limited has NO Catalyst without World of Warcraft. They have to eventually fill the void with a decent future title or two..or something...

    I don't care how much positive cash flow the company has.. There's no growth in a business without a catalyst.

    Electronic Arts could easily just sell off their 15% stake in The9 limited, just as Bank of America I believe sold off or reduced their stake in a Chinese Bank.

    A better question to ask here is if Electronic Arts has any future plans to introduce a MMORPG through The9 Limited. Maybe RAGE?

    Well... if "RAGE" is planned for The9 Limited then I guess we have a catalyst. Otherwise, I'd stay away from this one until research reveals a catalyst.

  • Report this Comment On June 28, 2009, at 12:46 PM, Varchild2008 wrote:

    Oops.. ID Software's "RAGE" as far as I can tell isn't a Massive Multiplayer Game... It might have a multiplayer component but I doubt a pay to play type.

    So.. again.. I don't see where EA would incorporate The9 limited into a future game title yet.

  • Report this Comment On July 02, 2009, at 7:13 AM, TMFMileHigh wrote:

    Hello Varchild2008,

    The9 and EA have a deal to distribute its FIFA Online game in Korea and China. More details on page 27 of the last-filed 20-F report:

    http://www.sec.gov/Archives/edgar/data/1296774/0001145549080...

    On the other hand, The9 yesterday said it would not be able to file a new 20-F report on time -- not a good sign. Plenty of risks remain, but this business isn't dead yet.

    FWIW and Foolish best,

    Tim (TMFMileHigh and @milehighfool on Twitter)

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