3 Small-Cap Stocks Below $5 Ready to Surge

Stocks trading for less than $5 have a special attraction to investors. Because of their cheap prices, smaller investors are able to buy a larger number of shares, while providing a better return opportunity than stocks in their full valuation. In other words, it’s a lot easier for a stock to surge from $3 to $6 a share than from $50 to $100 a share, for instance.

#-ad_banner-#But beyond pure psychology, there are also two fundamental reasons why stocks trading for less than $5 are attractive to investors looking for outsized gains.

The first is the mutual fund effect. Most mutual fund charters restrict managers from buying penny stocks and stocks that trade for less than $5. But once a stock crosses that $5 threshold, it often unleashes a wave of demand from high-powered institutional money managers who were forced to sit on the sidelines.

Second, stocks that trade for less than $5 are frequently small and micro caps, companies typically in the early stages of growth. That can definitely lead to additional volatility as the winners and losers duke it out. But in the longer term, just as I pointed out in this article, smaller capitalization stocks have a strong history of outperforming the market. Take a look below at how sharply small caps have outperformed the S&P 500 in just the past 12 years.

Taking all these lessons and synthesizing them together, here are my three favorite stocks trading for less than $5.

1. Gafisa S.A. (NYSE: GFA)
Gafisa is a Brazilian home builder with a market cap of $890 million. Shares are down sharply in the past 12 months as the Brazilian housing market has cooled and investors have shifted capital away from emerging markets.

This shift has caused Gafisa to drop 22% on the year, in spite of shares posting an amazing rally in August and doubling to $4. But despite this recently bullish movement, Gafisa still trades at a huge discount to the S&P 500, at just five times projected 2013 earnings of 78 cents. If shares traded with the same valuation as the S&P 500’s forward price-to-earnings (P/E) ratio of 14, then Gafisa would jump an astounding 260%.

2. RTI Biologics (Nasdaq: RTIX)
The health care and biotech industries are great places to find speculative stocks that trade for less than $5. But a lot of these companies don’t have any real earnings power, which is why I like RTI Biologics, as it’s expected to earn a nice 22 cents per share in 2013.

RTI Biologics is an orthopedic specialist, producing surgical implants that repair and promote the natural healing of human bone and tissue. But in spite of the company’s strong earnings profile, if RTI Biologics returned to its average forward price-to-earnings (P/E) ratio of 32 in the past 10 years, then shares would climb a hefty 46%.

3. Nevsun Resources Ltd. (NYSE: NSU)
Nevsun is a junior gold, silver, copper and zinc miner with a market cap of $836 million, making this stock a great way to cash in on the bullish trend in precious metals. Much like other mining stocks, particularly junior miners, Nevsun has struggled in the past year, with shares down more than 40% in spite of gold and silver hitting a series of new highs in the period.

But because earnings have held up relatively well, this has become a great value stock. With shares currently trading at just seven times forward earnings, converging to the industry average of 11 times would give shares a 57% boost. Nevsun also carries a solid 2.5% dividend yield in a time of historically low interest rates, which should add the to the shares’ appeal.

Risks to Consider: Stocks that trade less than $5 are more volatile than higher priced stocks and established market leaders. It’s also important to examine earnings, because even penny stocks can be expensive if they don’t have the income to support further growth.

Action to Take –> Buying stocks that are less than $5 is more speculative than investing in blue chips and market leaders. But having a certain portion of your portfolio dedicated to higher-growth opportunities is a great way to balance out core holdings that are more conservative and focused on capital preservation.