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)

Sept. 11, 2004 Price-to-Book Ratio

5-Yr Price Change Since

IAC (Nasdaq: IACI  )

****

1.07

(78.4%)

CIT Group (NYSE: CIT  )

**

1.36

(95.9%)

PMI Group (NYSE: PMI  )

**

1.33

(90.1%)

Semiconductor Manufacturing Int'l (NYSE: SMI  )

**

1.17

(74.0%)

Krispy Kreme Doughnuts (NYSE: KKD  )

*

1.68

(69.8%)

Sources: Motley Fool CAPS and Capital IQ, a division of Standard & Poor's.

Watch out!
How can you avoid value traps like these? My favorite method is borrowed from Professor Aswath Damodaran. In his book Investment Fables, Damodaran 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 Motley Fool CAPS database of 140,000-plus members 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 15 stocks that CAPS found hiding in the weeds, FTI Consulting (NYSE: FCN  ) intrigues me this week. The details:

Metric

FTI Consulting

Recent price

$44.98

CAPS stars (5 max)

***

Total ratings

295

Percent bulls

95.9%

Percent bears

4.1%

Price-to-book

1.82

ROE

10.0%

% Above 52-week low

24.5%

Sources: CAPS.

Interestingly, FTI is as intriguing for its growth potential as its value. A cavalcade of Wall Street's finest predicts that FTI will grow faster over the next years than it had during the prior three.

Why, you ask? "The financial crisis will accelerate restructuring and litigation activity more broadly and for longer, translating into more sustained earnings growth for [FTI]," wrote CAPS All-Star ValueMonkey last November. "Management noted that pipeline activity is accelerating, but cautioned on potential further dislocations in Europe."

Since then, industry peer Huron Consulting (Nasdaq: HURN  ) has reported accounting problems, torpedoing its stock and dragging shares of FTI and others lower. Fools buying now may benefit from what looks like a temporary and unjustified haircut.

But that's also just my take. Would you buy shares of FTI Consulting 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.

Fool contributor Tim Beyers is also a member of the Motley Fool Rule Breakers stock-picking team. Tim 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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