White Paper: Investing in Low-Priced Stocks - TheStreet

Investors come to the market with different goals and objectives, but many have one thing in common, an appetite for the excitement and volatility characteristic of stocks that are priced below $10 a share.

By nature, low-dollar stocks have a large degree of obscurity, due in part to the lack of institutional following and news coverage of their companies. Much to our delight, the result is an underfollowed universe of stocks that have the potential to become big winners in the future.

We have spent a lot of time here at

TheStreet.com

to develop a service that would provide investors with guidance into this profitable, but volatile space of the market. Our goal is to bring you unbiased, profit-driven analysis and commentary that remove the fears and unknowns of undiscovered stocks, ultimately making you money and enabling you to become a better investor.

To achieve this goal, we've developed an alert-based service called Stocks Under $10. We create and manage a model portfolio of single-digit stocks, send out timely alerts on breaking news, earnings, potential catalysts, and analyst actions for our portfolio stocks, and offer an overall sense of the Under $10 space. (Under our guidelines, 80% of our model portfolio stocks must be priced below $10 a share when we make a purchase.)

Given the sheer volume of issues in the Stocks Under $10 market, we cull the list by running a screen for stocks that meet a set of minimum criteria: Stocks must have market capitalizations of at least $100 million, 30-day average trading volumes of 100,000 shares, and a current price greater than $1 a share. These requirements, which sometimes limit our selection process, set a framework that keeps us from investing in bulletin board stocks that can be easily manipulated by Wall Street at the expense of the investing public.

We then complete a thorough process of due diligence that includes talking with management teams, reading

Securities and Exchange Commission

filings, scanning news, talking to traders, and reading other Wall Street analyst opinions and analyses before we issue an opinion on a stock. This process gives us a leg up on our competitors who have to spend time trying to decipher press releases and waiting for call-backs from management and IR teams when news hits the wires.

After our research process is complete, we rate our companies based on four components: management, underlying fundamentals, technical indicators and our proprietary Alpha factor.

We put a lot of emphasis on the management teams in the Stocks Under $10 space. For one, these are the people who are trying to engineer bigger and better things for the companies they run. Unlike larger companies that have layers of bureaucracy between management and employees, managers in the Stocks Under $10 market are interacting directly with salespeople, customers, suppliers, distributors, potential partners and employees on a day-to-day basis.

When it comes to the fundamentals, our No. 1 concern is, "Can the company fund its operations?" A lot of low-dollar-stock companies are burning cash to achieve their business objectives, opening up the risk of running out of money prior to profitability. We don't want to carry the risk of holding a company that could end up in Chapter 11.

We also add a small amount of technical analysis into our equation. Daytraders and momentum traders alike look to exploit the misinformation and potential leverage in the under-$10 universe to make money based on technical readings. We don't want to fall victim by ignoring charts. And while we don't use charts to make investment decisions, we do make timing decisions based on our opinion of a stock's chart.

Our Alpha component is made up of the components that allow us to tell which stocks could potentially be the next stock that soars more than 1,000% in price in just a matter of months. We studied 25 stocks that have come from seemingly nowhere to make large percentage moves, and have come up with a list of criteria -- such as a low float and minimal Wall Street coverage -- that must be met to be considered a potential Alpha play. We have also developed a system to look at stocks that have made big moves and know when it's time to take your gains and move on. While not a perfect science, it is insightful and profitable as long as we stick to our discipline and don't become greedy.

Roxio

, a stock we owned in the model portfolio, is a classic example of how our Alpha factor works in practice. The company -- now called

Napster

(NAPS)

-- owned the Napster brand for downloading music and met most of our Alpha requirements with its low float, small Wall Street following, and potential for big news that would scare the bears, which were short some 5 million shares.

Rapid sales of

Apple's

iPod and the release of

Microsoft's

Janus technology platform, which allowed for portable subscriptions, increased the buzz around Roxio. We ended up booking a 60% gain in our stake in less than two months. (Not all of our positions generate such enormous returns.)

In addition to

TheStreet.com

's proprietary rating system discussed above, we also categorize new picks as "Game Breaker," "Inflection Point" or "Stealth Stock" plays.

A Game Breaker is going to change the landscape of an industry, as

Intel

did in semiconductors, Microsoft in software,

Wal-Mart

in retailing and

Dell

in personal computers. Investors made big money owning these stocks by getting in before the crowd, and that's what we want to replicate when we add a Game Breaker to the portfolio.

We make Inflection Point plays when we see a broken business model on the mend, but without the participation of the stock. Think of

Nextel

(NXTL)

, which was trading at less than $5 a share in 2002. The company was buried in debt, and no one wanted to own the shares. Nextel CEO Tim Donahue remedied the company's problems, business improved, and the stock has traded as high as $29 this year. Investors who recognized Nextel's rebound early on pocketed strong returns.

We believe this success can be replicated with other stocks.

There are also times when we come across a stock that is flying under Wall Street's radar, with analysts and investors simply ignoring the fundamental strength underlying the business. These Stealth Stocks are often unknown names to the general public but can be hugely profitable, especially if they score well in our Alpha component.

A perfect example of a Stealth Stock is

Zi Corp.

(ZICA)

, which creates embedded software for cell-phone manufacturers that is designed to make using text messaging technology more user-friendly. We added the stock to our model portfolio before any analyst on the Street had picked up coverage. Just 48 hours later, Zi announced that cell-phone market share leader

Nokia

(NOK) - Get Report

licensed its technology. We then sold the stock, realizing a 36% gain.

We pride ourselves on being in constant contact with readers. We share our thought processes and the factors that go into our decision-making for you, and are constantly corresponding, via email, with readers who have specific questions on what we are thinking or saying. We believe this takes away some of the angst from investing in the under-$10 space and enables you to become a better investor.

William Gabrielski is a research associate at TheStreet.com and is accredited with a Series 7 license. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.

David Peltier is a research associate at TheStreet.com In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Peltier welcomes your feedback and invites you to send your comments to

david.peltier@thestreet.com.