"David's Dirty Dogs" -- D3 for short -- may sound more like a World Wrestling Entertainment trio than an investment fund, but D3 Family Funds' returns speak for themselves. $10,000 invested in the fund in 1999 would now be worth well more than $36,000 (despite the bursting of the Internet bubble). That amounts to an impressive annualized return greater than 24%, over a time period (1999 to the present) in which the S&P 500 has been in the red.

Renowned investor David Nierenberg, who heads up the Dirty Dogs, searches for unloved stocks in out-of-favor industries. What separates his value style, however, is that he fishes for such stocks in the small- to micro-cap range.

How he does what he does
Nierenberg exhaustively researches his companies, so he has the confidence to concentrate his portfolio in a select few stocks. Warren Buffett operates the same way. While broad diversification may be a safer play for most investors, luminaries like Nierenberg and Buffett, with the time and resources to extensively analyze companies, can earn incredible returns by knowing a few stocks cold.

How does Nierenberg find his select few? Good question.

In his interview with Motley Fool Hidden Gems advisors Tom Gardner and Bill Mann, Nierenberg said he seeks these five characteristics:

  1. Attractive valuation.
  2. Admirable management.
  3. Major emerging demographic trend.
  4. Strong balance sheet.
  5. Turnaround sales growth rate.

Valuation, though, was by far the most important. If an attractive valuation isn't there, Nierenberg moves on.

Not from concentrate
There is simply no reason to diversify if the market is handing you a 30% margin of safety on a company that has your full confidence. This was Buffett's rationale for buying up what has now become an 8% stake in Coca-Cola (NYSE:KO), a 12% stake in American Express (NYSE:AXP), and an 18% stake in Washington Post (NYSE:WPO).

Similarly, Nierenberg has bought huge stakes in Brooks Automation (NASDAQ:BRKS), Natus Medical (NASDAQ:BABY), and Mexican Restaurants (NASDAQ:CASA). He's done so because he's incredibly confident that these companies (and their investors) have bright futures ahead of them.

Who's running the show?
The most important factor after valuation is management, but Nierenberg says that analyzing a management team is "the hardest thing we do." What does he look for? Honesty and accountability, mostly. While the question is as simple as, "Do they do what they say they will do?", the answer can be far more complex.

Nierenberg likes managers who don't blame others for their shortcomings and remain wary of future challenges and competitors, even when business couldn't be better. A complacent manager, he reasons, will fail some time down the road.

The people factor
When Nierenberg finds a cheap company with a superior management team, he starts thinking Dirty Dog. That means a big position and potentially huge returns. Does it work all the time? No, but Nierenberg's track record speaks for itself.

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Coca-Cola is a Motley Fool Inside Value recommendation. The Fool has a disclosure policy.