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:

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, author of Investment Fables. In his book, he 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 135,000-member-strong Motley Fool CAPS database is a great place to start your search. I ran a screen for well-respected stocks trading at less than twice book value, whose returns on equity were 10% or more. Another qualifier was that stocks were trading no more than 25% above their 52-week low, leaving plenty of room for further gains.

Of the 38 stocks that CAPS found hiding in the weeds, Interactive Brokers Group (NASDAQ:IBKR) intrigues me this week. The details:

Sources: CAPS, Yahoo! Finance, Capital IQ.
Data current as of July 2, 2009.

In the last year, shares of Interactive Brokers have sold off as if it were a bank, a Citigroup (NYSE:C) in disguise. Nothing could be further from the truth. Interactive Brokers earns the bulk of its revenue from making electronic markets in more than 577,000 securities, options, and futures products. The company also operates a deep-discount brokerage for traders.

Lately, growth hasn't come easy. Interactive Brokers' market-making revenue fell 55% in the first quarter ended March 31. Overall interest in futures was lagging in June. Trading volume on the Chicago Board Options Exchange's Future Exchange fell 33% last month, Reuters reports. Overall volume at CBOE fell 10% in June, but is up a scant 2% year to date.

So why bet on this company? "[Interactive Brokers] has a very low PE. As a market maker and broker, they make money on spreads and commissions. They are not a bank like many bank-brokers," wrote CAPS investor noblepaladin last month.

"While people run away from the market during this downturn, eventually things will stabilize again," this Fool theorizes. "Even if they repeat the most recent quarter of 0.3 EPS for a few more quarters, that is 1.20 EPS per year and their brokerage has good growth."

Interactive Brokers also has a history of expanding its tangible book value via high returns on equity. The stock's current price-to-book ratio -- 1.23 -- could look cheap if this record of asset growth persists.

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

Further bargain-basement Foolishness:

• Take a look at our last litter of cheapskates.
• Bargain stocks are still out there.
• Whatever you do, avoid this Big Mistake.

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 Motley Fool Rule Breakers stock-picking team. He 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.