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
(Out of 5)

Book Value on
July 16, 2004

Return Since

ArvinMeritor (NYSE: ARM  )

**

1.30

(77.8%)

Gibraltar Industries (Nasdaq: ROCK  )

**

1.58

(65.2%)

Quantum (NYSE: QTM  )

**

1.59

(62.2%)

MBIA (NYSE: MBI  )

*

1.23

(92.2%)

Lennar (NYSE: LEN  )

*

1.94

(75.8%)

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

Watch out!
How can you avoid value traps like these? My favorite method is borrowed from Prof. Aswath Damodaran. In his book Investment Fables, 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 38 stocks that CAPS found hiding in the weeds, National HealthCare (NYSE: NHC  ) intrigues me the most this week. The details:

Metric

National HealthCare

Recent price

$38.30

CAPS stars (5 max)

*****

Total ratings

72

Percent bulls

91.7%

Percent bears

8.3%

Price-to-book

1.60

ROE

11.4%

% Above 52-week low

12.3%

Source: CAPS. Data current as of July 17, 2009.

This underfollowed operator of senior care and assisted-living facilities differs from peers such as Healthcare Realty Trust (NYSE: HR  ) , in that it isn't structured as a REIT. But it nevertheless pays a healthy dividend, yielding 2.7% as of this writing.

Most intriguingly to me, those few who do follow National HealthCare love it. All 16 All-Star CAPS investors who follow the stock rate it to outperform, and insiders still own more than one-quarter of the business.

Others simply like the economics of a business that caters to our aging population. "The growing need for senior healthcare in our country is the best reason for this rationale," wrote CAPS investor drcurt in February. "This company is very well run and will continue to be well run for many years to come. The recent change in management will assure this. Demand for expansion in the senior healthcare industry will mean that [National HealthCare] will continue to grow."

I agree -- but that's just my opinion. Would you buy shares of National HealthCare 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. Give it a trial run.

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 (1) | Recommend This Article (16)

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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 July 18, 2009, at 6:22 PM, breimondo wrote:

    I fell into this "trap" several months ago - fortunately I bought ARM at $0.35 and sold at $3.60 - helped with the extensive remodeling at home ... knowing a little about the company's history and direction helped though.

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