Arm Yourself With Explosive Under $10 Stocks

One way to develop a winning investment strategy is to examine a stock in your portfolio that's given you a big gain and dissect how you came to select it. Chances are, the strategy can be repeated, resulting in even more gains.

My chief task here at TheStreet.com is to manage the Stocks Under $10 service that assembles a portfolio from -- you guessed it -- stocks priced below $10 a share. One of our big winners in the portfolio is DynCorp DCP, a defense outsourcing company whose niche is in training police forces abroad. After we added DynCorp to the Stocks Under $10 portfolio back in November 2006, the stock price jumped 100% in seven months.

Now, not all of our stocks produced the gain that DynCorp did. (Our portfolio delivered a 14% return in 2007, compared with a decline of 2.7% for our benchmark, the Russell 2000. Please click here for a free trial of the Stocks Under $10 service.) But DynCorp provides an opportunity to examine the strategy we used to select it, and from that, pass along some suggestions that you may use to select stocks for your portfolio.

It's wise to develop criteria to use as a screen to narrow down the stock universe. We (my assistant Larsen Kusick and I) do that routinely in our research for the Stocks Under $10 portfolio.

We initially look for three criteria: stocks that are not generally followed by the market and certainly not by a large number of analysts; stocks that have growth potential over the next one to three years; and companies that are normally out of favor with the general public -- which are not difficult to find, considering that these stocks are trading in the single digits.

Our final criterion is the most important: We use a common-sense approach that is not defined by the numbers or anything you will read in an analyst's report. When looking at stocks that trade under $10, seldom will you find a stock that has solid financials and long-term growth potential, so it's important to identify whether the reward is worth the risk.

For example, although the homebuilders were seen as buys by many pundits months ago based on book value, our common sense -- which included all the for-sale signs around the country and higher living costs -- told us that demand was clearly slowing.

Using our initial criteria, DynCorp was a gem. The company was not widely covered by sell-side analysts -- or not well-known by the Street. In addition, it was out of favor with the general public, given last quarter's earnings miss. The upside was that DynCorp had several catalysts -- including the potential for large government contracts, given our presence in Iraq -- that had the potential to loft its growth substantially.

More specifically, defense stocks were booming in 2006; our continued conflict with Iraq was creating major increases in the U.S. defense budget. However, DynCorp, as a little, unknown defense company, was not participating in the boom. In fact, DynCorp dropped to below $10 from its May 2006 initial public offering (IPO) price of $15 after reporting a less-than-stellar quarter.

Back then, the Democrats took over the House of Representatives and the Senate. Many believed that a troop withdrawal from Iraq would soon follow. Since DynCorp -- at the time -- received most of its revenues from the Middle East, analysts viewed the Democrats' victory as a headwind.

This news, coupled with a mediocre quarterly earnings report, where the company reduced its full-year guidance, pushed the stock sharply lower, but we believed that the public was missing the bigger picture.