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 Rating

(out of 5)

2004 Book Value

Return Since

E*TRADE Financial (Nasdaq: ETFC  )

****

1.89

(88.2%)

Lexington Realty (NYSE: LXP  )

***

1.47

(70.8%)

Cray (Nasdaq: CRAY  )

***

1.80

(63.7%)

Flagstar Bancorp

*

1.76

(95.1%)

Centex (NYSE: CTX  )

*

1.80

(82.2%)

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

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 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 62 stocks that CAPS found hiding in the weeds, GameStop (NYSE: GME  ) intrigues me this week. The details:

Metric

GameStop

Recent price

$21.03

CAPS rating (out of five)

****

Total ratings

3,125

Percent bulls

95.7%

Percent bears

4.3%

Price-to-book

1.50

ROE

17.3%

% above 52-week low

24.4%

Sources: CAPS and Yahoo! Finance.

Data as of July 14, 2009.

Video games are big business, but not big enough for Sony. Sales at the maker of the PlayStation 3 console have declined to the point that Activision Blizzard (Nasdaq: ATVI  ) is threatening to concentrate on its rivals -- the Wii and the Xbox 360.

Would GameStop consider a similar move? Probably not, though every inch of shelf space reserved for the slowpoke PS3 is shelf space that could go to the next great game. But it may not matter: The gaming industry's hottest new properties are arriving online in greater numbers. Online gaming traffic here in the U.S. grew 22% in May compared with a year ago, researcher comScore reports.

Investors see numbers like those and worry that gaming mallrats are going all-digital, ruining GameStop's walk-in business. But this is like saying that video on demand has killed the DVD. Netflix (Nasdaq: NFLX  ) has already proven otherwise.

What's more, GameStop's cheap valuation compensates for the risk of owning the shares. "I feel that [GameStop's] upside [is] $30 to $36 in the next 12 months based on a P/E of 12 to 15 and EPS of roughly $2.40 a share," wrote CAPS All-Star matsummk in June.

Agreed, but that's also just my take. What you do? Would you buy shares of GameStop 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, GameStop, and Netflix are 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.


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