"Nothing under $5."
That was often the message I was greeted with by mutual hedge fund managers as I sat down to discuss my latest picks with them. As a Wall Street analyst, it was my job to help these managers discover winning ideas.
And unfortunately, many of them were restricted from buying any stocks priced below $5.
It's an arbitrary rule established by boards of directors at funds... but one that the rest of us can profit from.
That's because once a stock reaches $5, a lot of these same fund managers start to consider such stocks -- and if they like what they see, they'll push shares yet higher as they take a stake.
Here's a look at three stocks with each trading under $3 that could reach and surpass that $5 threshold in the year ahead.
1. Ceragon Networks (Nasdaq: CRNT)
Just a few years ago, this provider of high-speed wireless network equipment to emerging-market countries was a popular choice among fund managers. Its sales had surged from $184 million in 2009 to $445 million by 2011.
But the past few years have seen a pullback in capital spending by wireless service providers, and Ceragon's annual sales have slipped to around $350 million these days. Fund managers have decided they can find better growth opportunities elsewhere, and this stock has completely collapsed. The fact that sales and profits have missed the consensus forecasts for three straight quarters suggest has just added to this stock's pain.
Yet behind the scenes, Cergaon's business appears to be turning the corner. Management has been meeting with investors and analysts, and is speaking of a turnaround. In fact, the company saw a 25% sequential gain in new orders in the first quarter of 2014.
"This is particularly significant since (the first quarter) is usually relatively weak quarter for bookings," said CEO Ira Palti in the company's most recent conference call. Equally important, almost half of the new orders came from a recently released product line, known as IP-20, and new products tend to carry higher profit margins than legacy products. Surging demand for IP-20 caught management off guard, and production was slow to build fast enough.
"We will continue to ramp up as quickly as possible to accommodate the expected demand for IP-20," Palti added on that conference call.
This is a company sitting in the middle of a key global trend. Many emerging markets are skipping past the wireline telecom market and going straight to advanced high-speed wireless networks. That's why analysts expect sales to rebound 15% next year, to more than $400 million, while several years of operating losses should rebound to a profit of $0.25 to $0.30 a share next year. Ceragon reports second-quarter results July 28.
2. Liquid Holdings (Nasdaq: LIQD)
This company is counting on a rebound in its sophomore year as a public company. Its freshman year has been a doozy: Liquid went public last July at $9 a share -- and now trades below $2.
Blame goes to a lack of sales traction for its suite of cloud-based management tools for hedge funds. Sales of just $5 million in 2013 were far short of what investors had been anticipating during the IPO period. It also soon became apparent that the company didn't raise enough money during the IPO and a further capital raise would eventually be needed.
Few investors have an interest in a stock in advance of dilutive capital-raising. The fact that such a deal was done at just $1.25 a share in May 2014 shows how unloved this stock had become.
Yet this struggling financial software firm may be getting a second wind.
By the end of this March, it had built up a base of 119 clients, up sharply from 77 clients a quarter earlier. Around that time, HedgeWeek magazine cited Liquid as the "Best Risk Management Software Provider" for 2014. That likely has opened more doors for the sales force, and sets the stage for a higher client count at the end of the second quarter.
Analysts expect sales momentum to continue to build in coming quarters and predict that sales will exceed $15 million next year. That won't be enough to generate net income, but should be sufficient to attain positive operating cash flow. And investors think that should set the stage for self-financing, and no more of those unwanted capital raises like the kind that decimated this stock in May.
3. Merge Healthcare (Nasdaq: MRGE)
A key tenet of the Affordable Care Act (aka Obamacare) has been the widespread adoption of digitized medical records that can be more easily shared among doctors and hospitals -- and more importantly, cut down on the problem of faulty data entry that can lead to big medical mistakes.
The sweeping changes are likely to help this company see a lot more demand for its subscription-based software service that helps store and manage digital health care images in a wide range of subspecialties such as radiology, oncology and cardiology. (The company's platform is actually much broader than that, but that is just an example.)
The downside of Obamacare: It has had to slow down the transition to an all-digital health care environment, and hospitals now have more time to implement a new standard, known as ICD-10.
Yet once this transition phase is complete, Merge should see a healthy amount of new orders as hospitals upgrade to fully digital imaging systems. Merge is expected to report second-quarter results in August, and though the current sales trends are likely to be mediocre, management should be able to comment on a looming upturn in demand, which should set the stage for robust results in 2015 and 2016.
Risks to Consider: These are micro-cap stocks, which can prove to be especially vulnerable in a broader market pullback.
Action to Take --> These are all candidates for the "10% rule" I've been discussing recently. If they break out on the upside, by perhaps around 10%, then it is often a sign that the crowd is beginning to take notice of better days ahead. Trading volume is also a great way to track these kinds of stocks. If you see trading volumes steadily rise, it likely means that institutional investors are starting to build positions. The key is to own such stocks before too many institutions join the action.