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

Genworth Financial (NYSE: GNW  )

***

1.09

(53.6%)

Semiconductor Manufacturing International (NYSE: SMI  )

**

1.27

(71.1%)

MBIA (NYSE: MBI  )

*

1.38

(93.4%)

Furniture Brands International (NYSE: FBN  )

*

1.37

(76.3%)

American Axle & Manufacturing (NYSE: AXL  )

*

1.56

(72.5%)

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 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 19 stocks that CAPS found hiding in the weeds, infrastructure services firm Cloud Peak Energy (NYSE: CLD  ) intrigues me this week. The details:

Metric

Cloud Peak Energy

Recent price

$15.01

CAPS stars (out of 5)

***

Total ratings

37

Percent bulls

91.9%

Percent bears

8.1%

Price-to-book

1.92

ROE

38.3%

% above 52-week low

19.8%*

Sources: CAPS, Yahoo! Finance. Data current as of Dec. 24.
* Cloud Peak Energy began trading on Nov. 20.

Once more, I'm turning to my Foolish colleague Christopher Barker for a stock idea. Here's what he had to say about Cloud Peak Energy shortly after its November IPO:

Essentially, Rio Tinto (NYSE: RTP  ) has just sold a 52% stake in producing [Powder River Basin] coal mines to you -- the public -- for about a third less than Arch Coal paid for similar assets earlier in the year.

The stock has gained some since, but still trades for less than two times book value, and this for a company that's positioned to take advantage of export demand from Asia.

Interestingly, analysts don't have much to say about the long-term opportunity for Cloud Peak. Only one equity researcher is covering the company at present.

Color me thrilled. History shows that underfollowed small-cap stocks are very often some of the best the market has to offer. Chris' research makes me wonder if that's what we have here, too.

But that's my take. What would you do? Would you buy shares of Cloud Peak Energy 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 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 (2) | Recommend This Article (17)

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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 December 26, 2009, at 3:43 AM, Fool wrote:

    i like it well

  • Report this Comment On December 27, 2009, at 10:49 AM, jmsp8 wrote:

    I bought 200 on 11-24 @ $14.44 - - - just a gamble, but is seems like a reasonable buy. Will hold long term if it turns out to be a 2% or + dividend payer. Probably would add more if it drops below 13.

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