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

Return Since

IAC/InterActiveCorp (Nasdaq: IACI  )

***

1.14

(63.6%)

Genworth Financial (NYSE: GNW  )

***

1.01

(53.4%)

UTStarcom (Nasdaq: UTSI  )

**

1.53

(89.7%)

Allied Capital (NYSE: ALD  )

**

1.81

(75%)

XL Capital (NYSE: XL  )

**

1.39

(70.6%)

Sources: Motley Fool CAPS, Capital IQ (a division of Standard & Poor's), 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 return 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 145,000-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 32 stocks that CAPS found hiding in the weeds, infrastructure specialist Granite Construction (NYSE: GVA  ) intrigues me this week. The details:

Metric

Granite Construction

Recent price

$30.50

CAPS stars (out of 5)

****

Total ratings

261

Percent bulls

94.6%

Percent bears

5.4%

Price-to-book

1.44

ROE

12.1%

% Above 52-week low

12.4%

Sources: CAPS, Yahoo! Finance, as of Nov. 22.

For as much talk as there is about economic stimulus and its effects, infrastructure projects never grow old. They come and go in every economy, fueling returns for the likes of Chicago Bridge & Iron (NYSE: CBI  ) and Matrix Service. "[C]onstruction money will be spent," wrote CAPS All-Star TSIF in August. "Granite has a decent pipeline to keep it busy until something breaks."

That "something" is yet to be determined, but with debt at 37% of equity and just 26% of total capital, this cyclical business doesn't appear to face any immediate liquidity issues -- a good sign. Plus, the stocks trade for a reasonable 13 times trailing earnings, and pays a 1.70% dividend yield. Not a bad way to wait for infrastructure spending to recover.

But that's my take. What would you do? Would you buy shares of Granite Construction at today's prices? Let us know by signing up for CAPS today. It's 100% free to participate.

More bargain-basement Foolishness:

Granite Construction is a pick at Motley Fool Hidden Gems and Chicago Bridge & Iron is a Global Gains recommendation.

Fool contributor Tim Beyers is also a member of the 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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  • Report this Comment On November 23, 2009, at 3:18 PM, genhappy wrote:

    I bought 15,000 shares of this "value trap" in March for $ 2/share. How'm I doing ?

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