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 |
(out of 5) |
2004 Book Value |
Return Since |
---|---|---|---|
E*TRADE Financial |
**** |
1.89 |
(88.2%) |
Lexington Realty |
*** |
1.47 |
(70.8%) |
Cray |
*** |
1.80 |
(63.7%) |
Flagstar Bancorp |
* |
1.76 |
(95.1%) |
Centex |
* |
1.80 |
(82.2%) |
Sources: Motley Fool CAPS, Capital IQ, and 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 it, 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 62 stocks that CAPS found hiding in the weeds, GameStop
Metric |
|
---|---|
Recent price |
$21.03 |
CAPS rating (out of five) |
**** |
Total ratings |
3,125 |
Percent bulls |
95.7% |
Percent bears |
4.3% |
1.50 |
|
17.3% |
|
% above 52-week low |
24.4% |
Sources: CAPS and Yahoo! Finance.
Data as of July 14, 2009.
Video games are big business, but not big enough for Sony. Sales at the maker of the PlayStation 3 console have declined to the point that Activision Blizzard
Would GameStop consider a similar move? Probably not, though every inch of shelf space reserved for the slowpoke PS3 is shelf space that could go to the next great game. But it may not matter: The gaming industry's hottest new properties are arriving online in greater numbers. Online gaming traffic here in the U.S. grew 22% in May compared with a year ago, researcher comScore reports.
Investors see numbers like those and worry that gaming mallrats are going all-digital, ruining GameStop's walk-in business. But this is like saying that video on demand has killed the DVD. Netflix
What's more, GameStop's cheap valuation compensates for the risk of owning the shares. "I feel that [GameStop's] upside [is] $30 to $36 in the next 12 months based on a P/E of 12 to 15 and EPS of roughly $2.40 a share," wrote CAPS All-Star matsummk in June.
Agreed, but that's also just my take. What you do? Would you buy shares of GameStop at today's prices? Let us know by signing up for CAPS today. It's 100% free to participate.
More bargain-basement Foolishness:
- Take a look at our last litter of cheapskates.
- These are some of the worst stocks you can buy.
- Some stocks are pure speculation.