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) |
2005 Price-to-Book Ratio |
Return Since |
---|---|---|---|
PMI Group |
** |
1.29 |
(93.9%) |
Modine Manufacturing |
** |
1.67 |
(60.6%) |
Freddie Mac |
* |
1.74 |
(97.8%) |
Beazer Homes |
* |
1.60 |
(90%) |
OfficeMax |
* |
1.11 |
(46.2%) |
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
Metric |
|
---|---|
Recent price |
$22.01 |
CAPS stars (out of 5) |
***** |
Total ratings |
251 |
Percent bulls |
95.6% |
Percent bears |
4.4% |
Price-to-book |
0.97 |
ROE |
10.3% |
% Above 52-week low |
11.7% |
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
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:
- Take a look at our last litter of cheapskates.
- Is value investing dead?
- When it comes to investing, patience isn't just a virtue; it's a necessity.