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 Rating

(out of 5)

2005 Price-to-Book Ratio

Return Since





Modine Manufacturing (NYSE:MOD)




Freddie Mac (NYSE:FRE)




Beazer Homes (NYSE:BZH)




OfficeMax (NYSE:OMX)




Sources: Motley Fool CAPS, Capital IQ (a division of Standard & Poor's), and 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 145,000-member 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 19 stocks that CAPS found hiding in the weeds, business insurer Tower Group (NASDAQ:TWGP) intrigues me this week. The details:


Tower Group

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 Jan. 21.

Tower Group has two big advantages. First, at eight times trailing earnings, it's cheaper than both the industry at large and giant peers such as The Travelers Companies (NYSE:TRV), according to data from Yahoo! Finance.

Second, because the company is small and serving a niche -- property and casualty insurance for smaller businesses -- there's still plenty of growth to be had. Analysts call for Tower Group to boost earnings by 22.5% a year over the next five. Growth like that merits at least a double-digit P/E ratio, yet the company languishes in the single digits.

"Valuation. This business is cranking out ROE and is solidly undervalued based on margins alone. Recent pullback is an invitation to take part in a potential buyout," wrote CAPS All-Star greenwave3 in December.

I agree, but that's also just my take. What would you do? Would you buy shares of Tower Group at today's prices? Let us know by signing up for CAPS today. It's 100% free to participate.

More bargain-basement Foolishness:

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.