Penny-stock lovers are having a big laugh at the expense of blue-chip investors.

A list of blue-chip stocks selling at penny-stock prices reads like a Who's Who of government bailouts: Citigroup, the bankrupt-or-zombie-but-still-trading-above-zero General Motors, AIG (NYSE: AIG), Fannie Mae, and Freddie Mac.

It feels like a betrayal. Blue-chip stocks are supposed to be big and safe ... downright boring, even. Investors in blue chips expect steady growth and solid, inflation-beating returns. They don't expect shares to become virtually worthless.

Those are the risks penny-stock buyers (hopefully) knowingly take. Penny stocks are the ones that promise binary outcomes: wild upsides or bust. Now we have a parade of blue chips that are no longer investments but speculations on dubious business models.

Is Citigroup's loan portfolio really that bad? What will Fannie Mae look like in five years? Is it possible to extricate AIG's core insurance business from its credit default swap nightmare? Who the heck knows?

Investments are calculated risks based on the study of a business. When you can't even pretend to quantify those risks, you have speculation -- precisely what you have in these fallen blue chips and in many penny stocks.

Fortunately, we can combine the better qualities of classic blue chips and penny stocks to find some seriously intriguing investments -- we'll call them blue-chip penny stocks. Let's build one from the ground up:

Size matters
To capture the potential upside of penny stocks, we should focus on small caps -- stocks with market capitalizations of roughly between $200 million and $2 billion. As we've seen, large caps may not be too big to fail, but they're too big to grow by leaps and bounds.

I set a floor of $200 million because microcap stocks aren't usually established enough to satisfy the "blue-chip" part of blue-chip penny stocks.

Beware the bogus
We can limit a major downside of penny stocks by buying only small caps that are listed on major exchanges (in the U.S., that means the NYSE, the Nasdaq, and the Amex). The major U.S. exchanges have listing requirements that screen out many of the fly-by-night operations -- the kinds that send out spam emails pumping their stocks.

There are some legitimate companies that trade over the counter (Nintendo comes to mind), but fishing the OTC waters is not the best way to find the future 10-baggers I've written about in the past. It's much more likely that these become troubled stocks to sell.

Strength and performance
The beauty of traditional blue chips is that they're not just selling you a dream. In the best cases, they generate strong cash flows that are backed up by rock-solid balance sheets -- think Chevron (NYSE: CVX), ADP (Nasdaq: ADP), Wal-Mart (NYSE: WMT), and Pepsi (NYSE: PEP). We should expect no less from our small-cap stocks. Every company can promise a rosy future (analysts expect both Palm (Nasdaq: PALM) and Yahoo! (Nasdaq: YHOO) to have plus-15% growth in the next five years), but it's much easier to believe when the present is rosy, too.

They do exist!
So there you have it. It's possible to find stocks with high upside that, while volatile, aren't quite as boom-or-bust as penny stocks are. But only if we carefully choose to focus the small-cap portion of our portfolio on:

  • Market caps in the $200 million-to-$2 billion range.
  • Listings on major stock exchanges.
  • Positive cash flows and reasonable debt positions.

Using these criteria increases the chances that our small-cap investments will grow to become the next great blue chips.

The analysts over at our Motley Fool Hidden Gems newsletter service are putting the Fool's money where its mouth is. They are constructing a real-money portfolio by buying these blue-chip penny stocks -- although our team simply calls them "promising small-cap stocks."

These three companies fit the above criteria and are current portfolio candidates:

  • Under Armour
  • Horsehead Holding
  • Natus Medical

But none of these has become a purchase yet. Among the companies that have been deemed worthy of a real-money buy is a company the Hidden Gems analysts believe looks similar to McDonald's in its infancy. To view this company and the rest of the team's purchases, simply click here for a free 30-day guest pass. There's no obligation to subscribe.

Already subscribe to Hidden Gems? Log in at the top of this page.

This article was originally published June 4, 2009. It has been updated.

Anand Chokkavelu is like Miley Cyrus -- he likes the best of both worlds. He owns shares of McDonald's and Citigroup. Under Armour is a Motley Fool Rule Breakers choice. Wal-Mart is an Inside Value recommendation. PepsiCo is an Income Investor pick. The Motley Fool owns shares of Under Armour. The Fool has a disclosure policy.