Don't Miss This Cheap Stock

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:

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. Finally, I limited it to small-cap companies, though you could easily lift that restriction if you decide to run the screen yourself.

Of the eight stocks that CAPS found hiding in the weeds, Medicare and Medicaid services provider Centene (NYSE:CNC) intrigues me this week. The details:

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

It's tough to pick a stock that will benefit from Obamacare if it comes to pass. Though my Foolish colleague, Shannon Zimmerman, says the one to bet on is UnitedHealth Group (NYSE:UNH), Centene very well could be another.

For the unfamiliar, Centene manages government-subsidized health-care programs administered via Medicare and Medicaid. This can be good business; industry peer and Motley Fool Stock Advisor pick Amerigroup (NYSE:AGP) has been a market-beater since it was first recommended.

The trouble with these and related stocks is uncertainty. No one knows exactly what Obamacare will be, or whether it'll pass. Centene, at 8.5 times forward earnings, seems priced for a less-than-ideal outcome. (UnitedHealth trades for just less than 8 times forward earnings.)

But that's my take. What would you do? Would you buy shares of Centene at today's prices? Let us know by signing up for CAPS today. It's 100% free to participate.

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