Small-cap stocks generally carry a higher degree of risk than large-caps because they don't generate as much cash, are less capitalized and are usually more volatile.

Stocks that trade under $10 tend to carry an even higher degree of risk: Few research analysts cover the names in this group, and many of the stocks are completely out of favor with the public. However, the rewards of under $10 stocks can be impressive.

To separate the bad stocks from the good -- the Vonages (VG) and Sirius Satellites (SIRI) from the Vasco Data Systems (VDSI) and Allscripts (MDRX) , two stocks that now trade above $20 but began their run in the single digits (and have been members of the Stocks Under $10 model porfolio) -- start by following these three rules.

1. Review the Conference Calls for the Past Two Quarters

This is one of the first steps in our research process for the Stocks Under $10 model portfolio. After every quarter, companies provide a telephone number (or Web link) for investors to listen in as management outlines the financial results for the past three months. After management finishes with its presentation, analysts will ask questions about the quarter and usually inquire about the future of the business.

After listening to many conference calls, we can confidently say that most executives usually highlight the positives of the quarter, no matter what the underlying performance may be. So that you don't get drawn into this rosy outlook, you should focus more on the concerns of the analysts asking questions. Also, even though headlines tend to highlight the revenue and earnings of a particular quarter, margins, new products, backlogs and subscriber growth are also key data that can influence the stock price.

We recommend going back and reviewing conference calls from at least two quarters. This will help identify trends and also give you an understanding of management's ability to meet its goals. Reviewing these calls takes only about two hours and could tip you off to catalysts that are not widely known by the public.

For example, on Taser's (TASR) April 25 conference call, management said that the company could receive a huge order from France if Nicolas Sarkozy was elected president -- something we noted in our initiation piece for this stock. This past weekend Sarkozy was elected, and shares jumped 4% Monday morning on the news.

2. Understand the Company's Market

Before buying a stock, it is imperative that you analyze the sector. For example, a housing stock with high margins and solid earnings could seem like a low-risk, high-reward investment. However, a look at the overall housing industry will alert you that many of the stocks in this sector could continue to be under pressure for another 12 to 18 months because of tougher lending standards and higher inventories. That industrywide trend could pressure even the good names in the sector.

Also, problems in some markets could lead to opportunities in others. Gasoline prices are skyrocketing, and small-cap retailers -- which receive most of their revenue from the U.S. -- could see a decline in traffic trends as consumers tighten their budgets. However, high energy prices are very good for oil and gas drillers.

3. Make Sure the Reward Is Worth the Risk

Most stocks in the under $10 space are very risky -- it's the reason they are trading at such a low price. One of the most important steps before buying a stock priced under $10 is to assess its risk and make sure the reward is worth it.

For example, if shares of a biotech company have run up considerably on anticipation of a Food and Drug Administration (FDA) approval for a new treatment, it may not make sense to buy the company. Most of the potential reward is already priced into the stock, but if the FDA votes against the particular drug, the downside could be huge.

Our approach is to look at small-cap biotechs that are not dependent on one particular drug and have partnerships with some blue-chip health care and biotech players. Partnerships can bring in a steady stream of revenue while potential drugs are being developed. We would also look at the pipeline to learn what and how many drugs are in the various stages of development.

If a particular drug advances from phase I to phase II clinical trials, it will likely have a positive impact on the share price. Although that news would not generate the huge gain of a phase III drug receiving an FDA marketing approval, it would significantly reduce risk.

Going the Extra Mile

These three rules will get you started in picking potentially winning low-priced stocks. However, these are just several of the methods we use to find the hidden gems among a universe of mostly scorned stocks. Some other important data points to consider include insider buying, low turnover in management and solid fundamentals. It's also a good idea to read a company's 10-K filings dating back at least two years.