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 they're really just 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

American Capital (Nasdaq: ACAS  )

****

1.56

(86.3%)

Time Warner (NYSE: TWX  )

***

1.40

(31.2%)

New York Community Bancorp (NYSE: NYB  )

***

1.60

(17.8%)

LeapFrog Enterprises (NYSE: LF  )

**

1.91

(76.5%)

Leap Wireless (Nasdaq: LEAP  )

**

1.02

(42.4%)

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 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 24 stocks that CAPS found hiding in the weeds, infrastructure services firm Jacobs Engineering (NYSE: JEC  ) intrigues me this week. The details:

Metric

Jacobs Engineering

Recent price

$36.61

CAPS stars (out of 5)

*****

Total ratings

1,055

Percent bulls

97.2%

Percent bears

2.8%

Price-to-book

1.73

ROE

15.2%

% Above 52-week low

21.4%

Source: CAPS.

Sometimes, a turnaround is worth betting on. That's why CAPS All-Star mrindependent is investing in this stock. "Jacobs Engineering remains well positioned for the future with a diversified base of private and public sector customers," he wrote last week. He continued:

Currently selling for 1.8 times book value, which is far below its typical [price-to-book] ratio of 3. The current price/sales ratio is 0.4, which is much less than the company's "typical" [price-to-sales] ratio of 0.6. Patient investors will be rewarded.

I'm inclined to agree, if only because the construction slowdown that battered Jacobs in its fiscal fourth quarter won't last forever. At the very least, stimulus funds here and abroad should put more of Jacobs' civil engineers to work, while simultaneously making better use of heavy equipment from the likes of Caterpillar (NYSE: CAT  ) .

But that's my take. What would you do? Would you buy shares of Jacobs Engineering 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 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.


Read/Post Comments (1) | Recommend This Article (12)

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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 November 30, 2009, at 8:39 AM, SpiderJack wrote:

    did you listen to the conference call? slow, slow , slow recovery, protracted, muted , 1 Billion of canceled contracts?

    Invest in the greatest stock of the future a 4.60 stock with symbil ONTY. cancer treatment developer . next huge blockkbuster - stimuvax with Merck Kgaa.

    Just sayin -JEC is way too early to be jumping into.

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