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
Ratio

Subsequent Return

North American Palladium (AMEX: PAL  )

*****

1.43

(54.1%)

Dynegy (NYSE: DYN  )

***

0.82

(47.9%)

Conseco (NYSE: CNO  )

**

1.07

(66.2%)

Flagstar Bancorp (NYSE: FBC  )

*

1.91

(95.9%)

Apartment Investment & Mgmt. (NYSE: AIV  )

*

1.75

(20.3%)

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 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 140,000-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 15 stocks that CAPS found hiding in the weeds, Northwest Natural Gas (NYSE: NWN  ) intrigues me this week. The details:

Metric

Northwest Natural Gas

Recent price

$42.65

CAPS stars (out of 5)

*****

Total ratings

122

Percent bulls

95.9%

Percent bears

4.1%

Price-to-book

1.72

ROE

11.2%

% Above 52-week low

16.5%

Sources: CAPS, Yahoo! Finance. Data current as of Sept. 18.

Natural gas isn't the easiest market to be in right now. A futures rally ended this morning, after the government issued a report that said inventories among U.S. companies grew at a smaller-than-expected pace last week.

Meanwhile, executives at Devon Energy (NYSE: DVN  ) and other natural gas producers have formed an alliance to lobby Congress over a forthcoming climate-change bill that they say unfairly favors coal. Whether their efforts will be successful is unknowable, but CAPS investors such as brianmccurdy say that Northwest Natural Gas is a good play regardless:

Natural gas is a great transition fuel to a lower-carbon economy, and NWN is involved solely in the transport and storage of natural gas. That isolates it some from the high fluctuations in natural gas prices. Additionally, I think NWN is a very forward thinking company. They will constantly evaluate their business model, and change as they identify weaknesses. They are 148 years old, and have been in many different businesses during that time.

Agreed, but that's also just my take. Would you buy shares of Northwest Natural Gas 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. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Tim Beyers is 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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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 September 18, 2009, at 12:32 PM, Huayra wrote:

    "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"

    I don't agree, there are plenty.. it's just that there are so many companies, lots of small & mid caps, that it's tremendously difficult to find them and read through the earnings statements to find out if you're actually investing in a fundementally solid company which will deliver above average growth and investment returns.

    I have a few sub $5 penny stocks in my portfolio and for all these stocks I believe they will be good investments on a 3-5 year basis. This is not a buy recommendation to others, just the sub $5's I'm invested in: KAZ, UIS, FBP, NRF, S.

    I don't believe these will "punish the garbage-grabbers who buy them", but then I do have to admit these 5 only make up 25-30% or my stock holdings and that I'm currently almost back to 60% stocks, 40% cash total from 80-20% a week ago.

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