Creating The Perfect Portfolio: Small Cap Stocks

by: Larry Meyers

Today's article assembles further specifics towards creating The Perfect Portfolio, as outlined in an earlier article. In a series of articles on creating the Perfect Portfolio which you can find here, I focused on the following asset classes: Large Cap Growth Stocks, Large Cap Value Stocks, Mid Cap Growth Stocks and Mid Cap Value Stocks. Today I'll stuff the portfolio with Small Cap Growth and Value Stocks. As an old math teacher once told me, it's not a good idea to put all your eggs in one basket, unless you are absolutely certain that the path you've chosen is the best one for you.

With Small Cap stocks, I want to anchor the asset class with at least one ETF or mutual fund, and turbocharge the rest of the class with stocks I want to own at least until they reach what I think their intrinsic value may be (for value stocks). On a very, very broad basis, that means a PEG ratio somewhere around 1. At that point, it's possible that they may not have reached my intrinsic value calculation, if so, they may get removed from the portfolio, or they may get switched over to the Growth class. For those stocks, I'd like to see stocks with at least 15% annualized projected growth over the next five years. My goal is diversification, but more in asset class than sector or industry. I don't like purely mechanical models. I trust my gut as it has served me well over my investing years.

I'm grounding this asset class with a core position in the iShares Russell 2000 Growth Index (NYSEARCA:IWO) and iShares Russell 2000 Value Index (NYSEARCA:IWN), broadly diversified indices in which their top ten holdings only account for about 6.8% and 5.2% of total assets, respectively. The value index has a few interesting plays in it, including American Capital Agency (NASDAQ:AGNC) and American Capital, Ltd (NASDAQ:ACAS). The former is a REIT that pays a 19% dividend, thanks to enormous leverage. It borrows on a short-term basis and invests in higher-yielding mortgage-backed securities that are guaranteed by the U.S. government, earning the spread. American Capital does roughly the same thing, but operates as a business development company.

To add to this, I'm adding Portfolio Recovery Associates (NASDAQ:PRAA). The company buys charged-off debts from the major credit card companies and other creditors, then attempts to collect on them. They pay as little as they can and collect as much as they can. The result is 20% projected annualized earnings growth and it's trading at a P/E/ of only 14 on this year's earnings. SEI Investments Co. (NASDAQ:SEIC) provides investment and fund processing for institutions, advisors, and rich people. This profitable business niche is on track for solid growth going forward. Jos. A Bank Clothiers (NASDAQ:JOSB) is growing at a steady 15% clip and while I'm not fond of retail in general, they've developed a pretty solid brand and strong following. The company also carries $260 million in cash on its balance sheet and no debt.

I'd adding in the top holding of one of my favorite mutual funds (Royce Premier), which is Gartner, Inc. (NYSE:IT). The company provides independent and objective research and analysis on information technology (IT), computer hardware, software, communications, and related technology industries. It's projected to grow at a 20% clip annualized. Finally, I'm adding DGSE, Inc (NYSEMKT:DGSE), which I wrote extensively about here. This is the kind of stock I like to use to turbocharge my portfolio. With a short-term projected trading goal some 20% above its current price, and a longer term price target well above that, it's the kind of microcap that is worth making a speculative investment in. In a few weeks, investors will also get a much closer look at the gold revenues from SBT that will be folded into DGSE's earnings. The company also just extended a large term credit facility, so it has plenty of liquidity to expand.

Small Cap stocks take up 7% of the Perfect Portfolio. Next time, I'll dive into a group of ETFs to represent International, Emerging Markets, High Yield Bonds, Muni Bonds, Other Bonds, and Commodities.

Disclosure: I am long IWN, IWO, DGSE.

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