8 great stocks for under $10

By Harry Domash

Cheap stocks, say stocks trading under $10, have an undeniable appeal: You have the potential to score big returns.

Say you hop on a stock with great fundamentals but languishing in the $5-per-share range. It's not a stretch to imagine that stock doubling or tripling when it catches the market's attention. It would be hard to achieve those sorts of returns with stocks like Google (GOOG, news, msgs).

Unfortunately, scoring big gains on cheap stocks isn't easy. Most got cheap because market players spied serious fundamental problems that probably won't go away. Thus, many are likely to get even cheaper.

Here's a screen for spotting cheap stocks that have the potential to recover from the problems that sank their share prices.

It employs a tool -- favored by the pros but neglected by most individual investors -- to isolate the truly profitable companies in the cheap-stock universe and then pick the stocks in that group favored by the smart money. From those select candidates, the screen picks fast growers with the best chances of outperforming the market over the next few months. Here's how it works.

Cheap -- but not too cheap

I start by identifying stocks trading below $10.

Screening parameter: Previous day's closing price <=9.95

There's such as thing as too cheap. I rule out stocks trading below $2 because, in my experience, such stocks are very risky. Since I arbitrarily picked that figure, increase your minimum to as high as $5 if you want to reduce your risk.

Screening parameter: Previous day's closing price >=2.00

Stock screeners sometimes include dead or rarely traded stocks in their results. You can avoid that problem by specifying a minimum trading volume, which is the average number of shares traded daily over a specified period.

Most stocks trade hundreds of thousands of shares daily, although small stocks get less attention and may only trade 50,000 or so shares, on average, daily. I require a minimum 40,000 shares average daily volume over the past three months. Since the lower the volume, the higher the risk, increase the minimum to 100,000 if you want to reduce your risk.

Screening parameter: Average daily volume last quarter >= 40,000

More than 1,100 stocks passed my price and volume tests. Next, I isolate the most promising suspects by employing a powerful profitability test.

Truly profitable

Simply reporting positive earnings doesn't ensure that a company is making enough money to support its growth or to provide an adequate return to its shareholders. To judge that, you have to look at profitability ratios such as return on equity, return on assets or return on invested capital.

Of the three, you hear most about return on equity. However, return on invested capital (ROIC) is favored by many pros because it offers an especially insightful look at profitability.

Invested capital is what you'd be on the hook for if you bought the whole company. Return on invested capital is the return you'd receive on your investment if you did buy the company and paid off its debt.

What's especially interesting about ROIC is that it tells you whether a firm can profitably employ borrowed funds. For example, a firm earning a 10% ROIC could borrow at the current 5% or so corporate bond rate and make a worthwhile profit. Conversely, a 3% ROIC company would pay more servicing its debt than it would earn on the borrowed funds.

Using MSN Money’s Deluxe Screener, I set my minimum allowable return on invested capital at 10%, double the rate most corporations currently pay for borrowed funds. Try lowering the minimum to 7% or 8% if you want to see more stocks.

Screening parameter: Return on invested capital >= 10

What's it worth?

Valuation ratios describe the market's expectations for a stock. Low valuations signal low expectations, meaning that most market players don't like the stock. Conversely, high valuations connote in-favor stocks with high, possibly unrealistic growth expectations. These stocks typically suffer big losses when their growth falls short of expectations.

The price-earnings ratio (recent share price divided by 12 months' per-share earnings) is the most widely followed valuation ratio. But reported earnings tend to be volatile from quarter to quarter, distorting the price-earnings ratio.

The price-sales ratio (recent share price divided by 12 months' per-share sales) is a steadier gauge because quarterly sales don't fluctuate nearly as much as earnings. Price-sales ratios range from 1 to as high as 20, and sometimes even higher. There is no hard-and-fast rule, but I've found that stocks with ratios above nine or so are risky bets.

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