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 Rating

(out of 5)

2005 Price-to-Book Ratio

Return Since

PMI Group (NYSE: PMI  )

**

1.29

(93.9%)

Modine Manufacturing (NYSE: MOD  )

**

1.67

(60.6%)

Freddie Mac (NYSE: FRE  )

*

1.74

(97.8%)

Beazer Homes (NYSE: BZH  )

*

1.60

(90%)

OfficeMax (NYSE: OMX  )

*

1.11

(46.2%)

Sources: Motley Fool CAPS, Capital IQ (a division of Standard & Poor's), and 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 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, business insurer Tower Group (Nasdaq: TWGP  ) intrigues me this week. The details:

Metric

Tower Group

Recent price

$22.01

CAPS stars (out of 5)

*****

Total ratings

251

Percent bulls

95.6%

Percent bears

4.4%

Price-to-book

0.97

ROE

10.3%

% Above 52-week low

11.7%

Sources: CAPS, Yahoo! Finance. Data current as of Jan. 21.

Tower Group has two big advantages. First, at eight times trailing earnings, it's cheaper than both the industry at large and giant peers such as The Travelers Companies (NYSE: TRV  ) , according to data from Yahoo! Finance.

Second, because the company is small and serving a niche -- property and casualty insurance for smaller businesses -- there's still plenty of growth to be had. Analysts call for Tower Group to boost earnings by 22.5% a year over the next five. Growth like that merits at least a double-digit P/E ratio, yet the company languishes in the single digits.

"Valuation. This business is cranking out ROE and is solidly undervalued based on margins alone. Recent pullback is an invitation to take part in a potential buyout," wrote CAPS All-Star greenwave3 in December.

I agree, but that's also just my take. What would you do? Would you buy shares of Tower Group 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 Motley Fool Inside Value service, which spotlights stocks that Mr. Market has put on sale. You can try it free for 30 days.

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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