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)

2004 Price-to-Book Value

Return Since

Dynegy (NYSE:DYN)




TRW Automotive (NYSE:TRW)








Standard Pacific (NYSE:SPF)




Superior Industries




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 Damordaran, author of Investment Fables. In that 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 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 53 stocks that CAPS found hiding in the weeds, The9 (NASDAQ:NCTY) 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 June 25, 2009.

That's not an easy call. Activision Blizzard (NASDAQ:ATVI) pulled The9's license to distribute its ultra-popular World of Warcraft (WoW) multiplayer online game in China earlier this month. As a result, revenue and cash flow are likely to plummet in the short term, creating significant losses. The9's latest available 20-F annual report -- from June 2008 -- corroborates this assertion:

In the years ended December 31, 2006 and 2007, the total revenue attributable to the operations of the WoW game and WoW related product sales were RMB1,028,989,688, which represented approximately 99% total revenue, and RMB1,243,630,836, which represented approximately 92% total revenue, respectively.

So the company is doomed, right? Not so fast. I certainly wouldn't bet big on this business; there are too many unknowns. But we do know that at present levels, The9 trades for less than the cash on its books: more than $320 million, as of December.

We also know that Electronic Arts (NASDAQ:ERTS) owns a 15% stake in The9. You think executives there will just stand by and watch their $167 million wither away? I don't.

Oppenheimer is probably right: The9 will likely suffer losses and burn through some of its cash hoard as it pushes to launch and market new games. But the company needed just $37 million of capital investment in 2007, and much less than that in years prior. Bankruptcy isn't imminent.

My guess is that The9 has at least a two-year cash cushion. Mix in the possibility of EA stepping in as a white knight, and a medium-term bounce in the stock price seems likely. But that's just my take. What would you do? Would you buy shares of The9 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. Activision Blizzard and Electronic Arts are Motley Fool Stock Advisor selections. 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.