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Six Ways to Find a Good Cheap Stock

Glenn Curtis

Lots of people won't touch stocks that trade at less than $5 because those stocks tend to be illiquid and volatile, and they can't be purchased on margin.

Still, this doesn't mean you should avoid all of them. Value stocks could be a crucial part of your portfolio, and our coverage of value stocks here at TheStreet.com, and in my newsletter, The Era of Value, can help make that happen (click here for a free trial and find out how I've done with my own stock picking with a look at my portfolio). Now here are a few tips that will increase your success with your value portfolio.

• Look for companies that were previously on the radar screen of one or more major institutions. I say this because it means that if the stock were to move up above a certain break point (usually a $5 stock price and a $100 million market capitalization), that same firm may reinitiate coverage or again take a position. In turn, this recognition could propel the stock higher.
  
  
• Make certain management's past predictions match the company's actual performance. Remember, credibility is everything on Wall Street. It's mostly OK if a company is unprofitable, as long as it's making progress. But it is totally taboo to say you'll post a profit and then fall short over and over. So do yourself a favor and peruse old press releases to see if the company has lived up to its own expectations.
  
  
• Read the financial statements -- the income statement (the one you see in earnings reports), the cash-flow statement and the balance sheet. Is the company profitable, or at least cash-flow positive? Does it maintain an adequate credit line? Is there a mountain of debt that could come back to haunt it? Know the answers to these three basic questions and you'll be leaps and bounds ahead of most other investors, I assure you.
  
  
• Avoid companies with a large share count or complicated capital structure. Large quantities of common stock, warrants, options and convertible debt can dilute a company's earnings. And earnings are what you're paying for in the stock market.
  
  
• Be on the lookout for insider buying. Although there is no sure thing when it comes to investing, insider buying is usually a hint that better times may lie ahead. My suggestion: Look for companies in which two or more execs are buying stock at or above the current market price. This will give you the peace of mind that insiders are in the same boat as you.
  
  
• Determine if there is some other catalyst on the horizon such as a potential acquisition or a new product launch. It's this excitement that will draw other investors and drive the stock price up.

Sound complicated? Don't worry, it's really not. Here are some great examples of what I'm talking about.

On March 5 I recommended Prime Medical Services (PMSI:Nasdaq) on RealMoney.com (at $5.85 a share). My reasoning was as follows: The company has previously announced plans to sell off its low-margin vision-correction business. And I realized that if it managed to do so, it would not only generate an enormous amount of press, but it would also have a reasonable shot of exceeding Wall Street expectations (of 70 to 72 cents a share in 2002).

It's still too early to tell if the company will indeed achieve those goals. But the flurry of press releases that accompanied the announcement (to sell off the business) was enough to drive the stock to over $8 recently. This is a perfect example of why buying a company with a catalyst on the horizon (such as increased press attention) is so important.

This past October I was researching 3Com (COMS Quote). At that time, the stock was at a lowly $3.75, and most investors wouldn't come near it, given the lack of demand for networking products. But with the shares trading under cash, and at only 0.6 times book value, I lit up with excitement.

This was my logic: Networking equipment would eventually come back. 3Com had plenty of cash to weather the storm. Its capital structure was simple: 356 million shares, and dilution not a factor. And sooner or later, I assumed that if even a glimmer of hope were to emerge for the industry, the retail and institutional community would jump back on board.

Anyway, after management suggested to Wall Street in a news release that the worst was probably over, investors piled back in, and I was able to sell the stock at $5.12 in late February -- a 36.5% gain. Not too shabby for five months' work, huh? Another stock that shows how well this game can work is BE Aerospace (BEAV Quote), which has more than tripled its post-Sept. 11 low. On the other hand, my experience with priceline (PCLN Quote) -- which dropped to $4 before I sold it -- shows the risks here.

The bottom line is that it's more common for a $5 stock to go to zero than to make a comeback. So do your homework before getting involved -- you'll be happy you did.

Be sure to check out my biweekly value investing newsletter, click here.