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:


CAPS Stars
(out of 5)

2005 Price-to-Book

Return Since

Lexington Realty Trust (NYSE:LXP)




American Capital (NASDAQ:ACAS)




Bank of America (NYSE:BAC)




XL Capital (NYSE:XL)








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 150,000-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 36 stocks that CAPS found hiding in the weeds, Res-Care (NASDAQ:RSCR), a specialist provider of health care services for the disabled, intrigues me this week. The details:



Recent price


CAPS stars (out of 5)


Total ratings


Percent bulls


Percent bears






% Above 52-week low


Sources: CAPS, Yahoo! Finance. Data current as of Feb. 19.

Shares of Res-Care are trading at a depressed multiple; less than 9 times next year's normalized earnings. Five years ago, the stock commanded a premium closer to what peer Providence Service (NASDAQ:PRSC) gets today.

What's happened in the interim? Gross margin and returns on capital are down slightly as revenue growth has slowed. Normalized earnings fell off a cliff in 2007 and 2008, but recovered nicely in 2009; margins have also seen a quality uptick within the last year. Analysts now expect the company to improve its bottom line by an average of 9% annually over the next five years.

As CAPS All-Star mrindependent wrote in pitching the stock recently, investors' selling of the stock has been too extreme, leaving Res-Care priced as if it won't meet reduced expectations. I'll be taking advantage of the bargain by going long in my CAPS portfolio.

Now it's your turn to weigh in. Would you buy shares of Res-Care at today's prices? Let us know by signing up for CAPS today. It's 100% free to participate.

More bargain basement Foolishness:

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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.