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 | 2004 Price-to-Book Ratio | Return Since |
|---|---|---|---|
| E*TRADE (Nasdaq: ETFC) | **** | 1.91 | (88.1%) |
| Flextronics (Nasdaq: FLEX) | **** | 1.23 | (47.4%) |
| American Capital (Nasdaq: ACAS) | *** | 1.58 | (85.9%) |
| Saks (NYSE: SKS) | ** | 0.84 | (40.5%) |
| Ambac Financial (NYSE: ABK) | * | 1.71 | (98.4%) |
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 135,000-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 25 stocks that CAPS found hiding in the weeds, Teleflex (NYSE: TFX) intrigues me this week. The details for this Motley Fool Inside Value pick:
| Metric | Teleflex |
|---|---|
| Recent price | $45.73 |
| CAPS stars (out of 5) | ***** |
| Total ratings | 84 |
| Percent bulls | 91.7% |
| Percent bears | 8.3% |
| Price-to-book | 1.24 |
| ROE | 20.1% |
| % Above 52-week low | 22.9% |
Sources: CAPS, Yahoo! Finance.
Data current as of Aug. 17, 2009.
Teleflex is an old pick for Inside Value. Advisor Philip Durell singled out the stock in the August 2006 issue of the newsletter. Fortunately, the thesis is timeless: Teleflex combines modest organic growth with small yet strategic acquisitions, resulting in bountiful free cash flow used for, among other things, generous dividend payments.
The numbers are worth eyeballing. From 1997 to 2007, for example, Teleflex increased its dividend payment 12.38% annually, to $1.25 per share. This year, the company is on track to distribute $1.36 for every share held, up another 8.8% from two years ago.
Contrast that with General Electric (NYSE: GE), a much larger industrial conglomerate, which recently reduced its dividend payment to cut costs. Impressive, no? Mix in a commitment to invest only in its most profitable business units, and Teleflex begins to look like a very attractive long-term holding.
But that's just my take. Would you buy shares of Teleflex at today's prices? Let us know by signing up for CAPS today. It's 100% free to participate.
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