Stocks Too Good to Be True

"One of the big mistakes value investors can make is to be too enamored with
absolute cheapness. If you focus on statistical cheapness, you’re often driven to businesses serving shrinking markets or that have developed structural disadvantages
that make it more likely they’re going to lose market share."
-- Bill Nygren, manager of the respected Oakmark mutual funds

It's a classic new-investor mistake: seeking seemingly cheap stocks, while neglecting to consider many other factors. A low price-to-earnings (P/E) ratio can seem very enticing, but it might lure you toward losses.

Many different factors can make stocks appear cheap; the P/E ratio is one of the most common culprits. I screened for familiar companies with P/Es of 12 or lower and found these, among others:

Data: Motley Fool CAPS.

While both companies might seem like bargains because of their P/Es, looking closer reveals that both sport those low ratios for good reason. Advanced Micro Devices has long struggled against competitor Intel, and BP is on the hook for a major oil-spill cleanup of uncertain scope.

Low from high
You'll also find companies that seem too good to be true among those that have fallen significantly from their 52-week highs:

Data: Motley Fool CAPS.

Monsanto shares are depressed by a multitude of factors, including slipping sales of its Roundup plant killer, and growing controversies over its genetically modified seeds. First Solar faces significant competition, along with broader concerns about oversupply within its industry. And Goldman Sachs must contend with a serious and ongoing SEC investigation.

High yield, low expectations
Finally, a suspiciously tantalizing dividend yield could also signal a dubious investment:

Data: Motley Fool CAPS.

Before you start drooling, a little research will reveal that Cedar Fair is sagging under heavy debt, Earthlink's revenue has been shrinking, and World Wrestling Entertainment is paying out more in dividends than it's netting in income. The market is telling us that these dividends may be too good to be true.

The real deal
The stocks that truly are too good to be true won't necessarily post the most eye-catching ratios or yields. But they will sport impressive track records and strong competitive advantages.

To dig up a few candidates, I searched for companies with revenue growth rates of 8% or more, P/E ratios of less than 25, and returns on equity (ROE) of 20% or more. Here's a sampling of the contenders I found:

Data: Motley Fool CAPS, Yahoo! Finance.
*14-year return.

Instead of getting excited by one or two extreme numbers, try to look at a company's big picture. Seek companies with lots of strong metrics, instead of a few eye-popping standouts. The companies above have performed well in recent years, and they're positioned to benefit when the economy really gets cooking again. They may not be dirt cheap by traditional valuation measures, but good quality stocks never are.

Don't look for cheapness alone. Solid companies trading at attractive prices have a much better shot at rewarding you for many years to come.

If you'd like some help finding them, take a free 30-day trial of our Motley Fool Stock Advisor newsletter. Its team of analysts, headed by Fool co-founders David and Tom Gardner, analyze multiple metrics to evaluate companies' competitive advantages and valuations. Their picks sport average returns of more than 59%, vs. just 2% for the S&P 500. Click here to learn more.

Longtime Fool contributor Selena Maranjian owns shares of Apple and First Solar. Best Buy, Intel, and Monsanto are Motley Fool Inside Value choices. First Solar is a Motley Fool Rule Breakers recommendation. Apple and Best Buy are Motley Fool Stock Advisor picks. The Fool has created a covered strangle position on Intel. Motley Fool Options has recommended a bull call spread position on Best Buy. Motley Fool Options has recommended a synthetic long position on Monsanto. The Fool owns shares of Best Buy. The Motley Fool is Fools writing for Fools.