The Stocks Under $10 newsletter is about more than just finding the next Microsoft (MSFT) - Get Report or Intel (INTC) - Get Reportearly in its life cycle. Making money in low-dollar stocks also requires a keen sense of what not to buy. Here's a rundown of how we spotted one rotten apple among the bunch earlier this year, saving readers from a potential catastrophe.

Since our first bearish report on May 21,

Rite Aid

(RAD) - Get Report

has lowered profit guidance twice, and missed monthly comp sales estimates. Management delivered its most recent shortfall last week, saying that increased competition from mail-order prescriptions caused Rite Aid to fall short of the revenue level it reached in 2003, when the company saw increased traffic during the California grocery workers' strike.

In addition, the company cut its 2005 sales forecast and said it now sees earnings coming in between 3 cent and 12 cents a share versus its previous guidance of 16 cent to 22 cents a share. This, on top of a Morgan Stanley downgraded and a Merrill Lynch sell recommendation earlier in the week pushed the stock near its 52-week low at $3.36 a share, 28% below its May price.

When we were first putting the newsletter together in May, searching through stacks of pages full of stocks trading under $10, we noticed a lot of familiar names. For one, there were dozens of former highflying technology behemoths like

Sun Microsystems

(SUNW) - Get Report

,

Nortel

(NT)

and

Lucent

(LU)

but those stocks had already had their boom day in the late 1990s. There were a handful of airlines like

Delta

(DAL) - Get Report

and UAL (UALAQ:OTC BB), but these stocks seem to be permanently mired by high-fuel expenses, exorbitant labor costs and defined pension liabilities.

Rite Aid was also on that list. Shares of the country's third largest pharmacy chain had been down since an accounting scandal was uncovered in 1999, when the stock was trading around $50. But value investors were circling around Rite Aid in May, as the stock had recovered more than 30% in the past year, and the industry was consolidating.

CVS

(CVS) - Get Report

and a Canadian private investment group had just purchased Eckerd from

J.C. Penney

(JCP) - Get Report

, and competitor

Duane Reade

(DRD) - Get Report

was taken private for a hefty premium. The speculative forces of the stock market were now taking over and investors, hoping not to miss the next takeover in this sector, quickly bid up Rite Aid.

At this point we ran the company through our test that looks at the financials, management, share price, technical indicators and our proprietary Alpha factor that gauges a stock's ability to make a large percentage gain on news. If there was any potential for Rite Aid to move higher, we didn't want to be left out of the move.

Within an hour of beginning to read up on the drug retailer, we knew something was amiss, and the stock wouldn't be added to the model portfolio. We were concerned by a drop in Rite Aid's same-store sales, while the company's debt ratios were ballooning as it struggled to keep up with larger competitors

Walgreen

(WAG)

and CVS. With a large trading float and minimal short interest, the stock also scored poorly in our Alpha factor. Finally, the new management team, no matter how far removed from the former troubled one, had yet to deliver consistent results and regain the confidence of investors.

Even at current levels, where some investors might be tempted to make a value play in Rite Aid, we believe there are much better names to own in the under $10 space. New readers who may have already been holding on to the stock should use any strength from here to exit out of this name.

Image placeholder title

P.S. Remember, stocks priced under $10 have the potential to move quickly. So, you might want to get our current recommendations now with a

free trial

to TheStreet.com Stocks Under $10.

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. Gabrielski welcomes your feedback and invites you to send your comments to

william.gabrielski@thestreet.com.

Interested in more writings from William Gabrielski? Check out Stocks Under $10. For more information,

click here.

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.