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

CAPS Stars
(out of 5)

2004 Price-to-Book Ratio

Return Since

CompuCredit (NASDAQ:CCRT)

***

1.52

(76.4%)

Jones Apparel Group (NYSE:JNY)

**

1.68

(49%)

Freddie Mac (NYSE:FRE)

*

1.70

(96.2%)

American Axle & Manufacturing (NYSE:AXL)

*

1.84

(79.1%)

Electronics for Imaging (NASDAQ:EFII)

*

1.69

(47.1%)

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 140,000-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 17 stocks that CAPS found hiding in the weeds, Sun Healthcare Group (NASDAQ:SUNH) intrigues me this week. The details:

Metric

Sun Healthcare

Recent price

$8.28

CAPS stars (out of 5)

*****

Total ratings

234

Percent bulls

97.4%

Percent bears

2.6%

Price-to-book

0.85

ROE

26.1%

% Above 52-week low

12%

Sources: CAPS, Yahoo! Finance.
Data current as of Aug. 27.

Two statistics jump out at me when I read this table. First, return on equity, at more than 26%, speaks well of management's ability to put shareholder equity to good use -- a positive sign for long-term investors.

Second, Sun Healthcare trades for below book value, and we've seen some big book value winners over the past year. JetBlue (NASDAQ:JBLU), which traded for slightly less than tangible book value on Jan. 2 of last year, ended 2008 up 23.9%.

Yet Sun Healthcare isn't as good a book value tale as JetBlue was; the stock trades for a little more than seven times its tangible book value as of this writing. Still, with ROE as high as it is, I'm inclined to give this stock a closer look, especially now that Sun Healthcare is paying down debt.

And I'm not alone. "This is a well-run company," wrote CAPS All-Star greenwave3 earlier this month:

Despite management complaining about low margins, [Sun Healthcare] is still gushing with free cash flow. This one looks really cheap. Even with lower margins, [Sun] is still a cash cow.

Agreed, but that's also just one Fool's take. Would you buy shares of Sun Healthcare at today's prices? Let us know by signing up for CAPS today. It's 100% free to participate.

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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.