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 instead, they're 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

Lexington Realty Trust (NYSE:LXP)

****

1.64

(62.2%)

Flextronics International (NASDAQ:FLEX)

****

1.50

(40.3%)

Radian Group (NYSE:RDN)

**

1.20

(84.6%)

LeapFrog Enterprises

**

1.78

(66.0%)

THQ (NASDAQ:THQI)

**

1.46

(49.6%)

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 18 stocks that CAPS found hiding in the weeds, specialist biotech Cephalon (NASDAQ:CEPH) intrigues me most this week. The details:

Metric

Cephalon

Recent price

$54.74

CAPS stars (out of 5)

****

Total ratings

324

Percent bulls

95.4%

Percent bears

4.6%

Price-to-book

1.99

ROE

12.0%

% Above 52-week low

4.2%

Sources: CAPS, Yahoo! Finance.
Data current as of Oct. 23.

Typically, I prefer to leave biotech investing to experts such as Brian Orelli and my Motley Fool Rule Breakers teammate Karl Thiel. But Cephalon is uncommonly appealing to me for two reasons:

  • At less than 9 times forward earnings, the stock is priced below peers GlaxoSmithKline (NYSE:GSK) and Johnson & Johnson (NYSE:JNJ), and what the Street expects from the underlying business in terms of earnings growth.
  • Cephalon has a popular product -- Nuvigil -- for treating sleep disorders, which afflict 60 million Americans. The FDA is currently reviewing Cephalon's petition to allow Nuvigil for treating jet lag; approval could lead to high-margin income gains.

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