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

CAPS Stars
(out of 5)

Book Value,
6/22/2004

Price Change
Since

Human Genome Sciences (Nasdaq: HGSI)

***

1.69

(76.9%)

R.R. Donnelley & Sons (NYSE: RRD)

**

1.91

(64%)

Hitachi (NYSE: HIT)

**

1.11

(57.5%)

Semiconductor Manufacturing Int'l (NYSE: SMI)

*

0.04

(76.7%)

La-Z-Boy (NYSE: LZB)

*

1.89

(78.7%)

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 Damordaran, author of Investment Fables. In it, he 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. I qualified it by also limiting the screen to stocks trading no more than 25% above their 52-week low, leaving plenty of room for further gains.

Of the 52 stocks that CAPS found hiding in the weeds, France Telecom (NYSE: FTE) intrigues me this week. The details:

Metric

France Telecom

Recent price

$22.27

CAPS stars (5 max)

****

Total ratings

393

Percent bulls

95.2%

Percent bears

4.98

Price-to-book

1.51

ROE

14.7%

% Above 52-week low

6.7%

Sources: CAPS.

Those who like France Telecom like it most for its high dividend yield, currently north of 8%. To them, it's like a bond with benefits.

"Given how I think the dollar will perform against the euro (poorly) and the dividend, I'll rate this an outperform," wrote CAPS All-Star jmt587 in December. The stock is down roughly 15% since.

So be it; patience is an enriching virtue with dividend payers. Just ask our Motley Fool Income Investor team. They've been recommending France Telecom -- which they call France's version of AT&T (NYSE: T) -- since January of 2006 and have thus far earned a better-than-11% total return, thanks entirely to dividends. (The stock trades for less today than it did when it was first recommended.)

Today, France Telecom trades for about 10 times trailing earnings. By itself, I wouldn't place much stock in the company's P/E. Mix in a meaty yield and France Telecom strikes me as a likely market-beater, and I've rated it as such in my own CAPS portfolio.

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

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