Building The Perfect Portfolio: Best Small Cap Stocks

by: Brian Nichols

How to build the perfect portfolio is a widely-debated topic, with many different opinions regarding the matter. Most financial advisers will tell you to invest 7% - 8% in each stock and to be diversified, which basically means to have a variety. We will discuss how to build the perfect portfolio without a "one system fits all" strategy. I will discuss several stocks that are both good for short, long, and everything in between-- along with percentages to better position yourself for success.

I have never agreed with the 7-8% holding rule within a portfolio. When I first began investing I was starting with roughly $5,000. Although investing with the 7% rule would have limited my risk, it was not going to grow my portfolio at the speed that I desired. The way a portfolio is divided should depend on the size of the portfolio and not a "one system fits all." With a $5,000 portfolio I was 19 years old, using money that I had saved while working in college-- and I was using it as a way to educate myself about the market. But over the years my goals have significantly changed and my willingness to take risk has declined. Therefore, as your portfolio grows your goals change as well.

Below is a general guideline that I have always used as my portfolio has grown through gains and additional investments. The chart shows what I believe is the best way to divide a portfolio by the total number of holdings to give the highest potential for gains while minimizing risks.

Portfolio Value Number of Stocks
$5,000 - $10,000 2 - 3
$10,000 - $20,000 4 - 6
$20,000 - $50,000 7-10
$60,000 - $100,000 11-14
$100,000 - $250,000 15 - 20
$250,000 - $500,000 20 - 30

Dividing Your Portfolio

There is no standard or correct way to diversify or divide your portfolio. There are too many factors involved for one standard method. My goal is to maximize the reward while minimizing the risk by purchasing shares that present value, or that have fallen for reasons that are not related to the company. Yet someone else who is near retirement may wish to minimize risk but most likely still desires a decent reward, therefore this person may prefer bonds or cash. It's impossible to give a formula that will work for everyone, yet I have had success with the formula above.

I currently hold 15-20 stocks at any given time and diversify the stocks based on my long-term goals. My idea of diversification is much different than the average investor, and I won't say that it will work for everyone but it has worked for me. When most people think of diversification in a portfolio they are speaking of a variety of stocks, mutual funds, bonds, emerging markets, etc. Along with having a variety of securities in all sectors or industries to limit risk. I use diversification in my portfolio to invest in stocks with different levels of potential rather than a variety of industries or sectors. I have been investing in stocks with this concept for the last two years, when I was forced to change my investing strategy as my portfolio became larger.

Investment Categories

I place investments into six categories and utilize each in my portfolio. Each has a purpose ,and -- rather than concentrating on diversifying with different industries -- my goal is to diversify my portfolio with the type of stocks that I choose. And like I said, this isn't for everyone, but I have tried various strategies over the last few years and I am yet to find one with returns such as diversifying your portfolio with stocks that serve a different purpose. Below is a chart of the six categories of stocks that I use in my portfolio along with the percentage of my portfolio that each category represents within my portfolio.

Long-Term Yield 30%
Long-Term Value/Growth 20%
Short-Term Value 20%
Short-Term Growth 15%
Small Cap 10%
Emerging Markets 5%

Over the last four weeks we have discussed different methods to diversify your portfolio with several sub-categories that are listed above. Today we will discuss what may be the most exciting, small-cap investments. Small-cap stocks can give investors the bragging rights to say that they found a large company when it was small. And it can also provide an incredible reward if an investor can find value in a small company then hold it while it grows larger. However, more times than not small-cap stocks continue to be small, and very rarely grow much larger. In fact, most small cap companies remain operational through the money raised being a publicly traded company. During this piece I will list a few areas that I look for in small-cap stock along with specific investments and how I believe investors should trade these stocks.

My first rule with any small-cap investment is that the company must be established and have a working product. This immediately eliminates most small biotech companies which are by far the most popular of small-cap investments. I have watched as investors pour large amounts of money into a speculative biotech company and lose their investment when the company's product fails. This happens more times than not, however, investors can return the same level of gains on a small biotech company that already has an approved product in a growing industry but is yet to be discovered. And to me there is only one company that falls into this category, and I believe it's the best small cap biotech company within the market, Acura Pharmaceuticals (NASDAQ:ACUR).

Acura Pharmaceuticals has everything that I look for in a small cap biotech company: it's a profitable company; it has an FDA approved technology; it's substance appeals to one of the largest medical issues in the U.S.; and it trades with less than 110,000 shares per day which means it's somewhat unknown. The company's patent protected AVERSION technology, which is an abuses deterrent, may very well change the way physicians prescribe pain medication. The company's technology is FDA approved with an oxycodone based drug Oxecta, which is a product of Pfizer (NYSE:PFE). Acura's business model is very simple: The company receives a percentage, most believe 10%, from the sales of Oxecta which is manufactured and marketed by Pfizer, which is arguably the best within the industry. However, the company also has several additional drugs in the pipeline, with Pfizer, that incorporates the AVERSION technology with other abused drugs such as hydrocodone. I believe that as a small cap stock ACUR is a homerun with its valuation being $157 million. The company's presenting a technology that can give physicians the peace of mind in knowing that there patients aren't abusing the pain medication that's being prescribed. And with an estimated 70% of every adult in America experiencing at least one episode of acute pain per year the market for Oxecta could be huge. The oxycodone market is approximately 50 million prescriptions per year, and I believe that Oxecta will account for a large number of this market within the next three years. However, the large gains for this stock should be continuous, because hydrocodone is prescribed more than 130 million times per year, which is the most prescribed drug, and I believe the company's next drug with hydrocodone could result in a multi-billion dollar company during the next five years. And although small biotech companies are speculative this is one that appears undervalued and has a large amount of upside over the next few years, which makes it a great investment.

Speculation is the key in small cap stocks and sometimes you have to invest based on what you believe will become a trend. And one market that I believe will continue to grow is truck brokerage firms. The market for worldwide logistics is more than $3 trillion, and the U.S. is 33%, yet the market for truck brokerage firms is approximately $50 billion. I believe the truck brokerage market will grow at a remarkable rate over the next five years, much faster than its current 2x GDP, because of the benefits associated with a brokerage firm. A brokerage firm connects the shipper to the supplier and gives both parties more options and ultimately more business from a larger selection. There are more than 10,000 licensed brokerage firms in the U.S. and roughly 20 create revenue of more than $200 million per year, this creates the perfect opportunity for a publicly traded company with a large amount of funds to capitalize and grow through acquisitions such as XPO Logistics (NYSEMKT:XPO).

I have always felt the truck brokerage industry would expand, however I never found a company within the market that I believed presented value. My perception changed once Bradley Jacobs announced that he was investing $150 million in XPO Logistics and taking control as CEO. This company has a market cap of just $83 million and is operating in one of the largest industries in the world, and has a CEO with a long history of creating billion dollar companies out of thin air. Jacobs has created four multi-billion companies in three different industries. However, the transportation industry is by far the largest industry in which he's ever attempted this feat. It's also the first time he's ever bought a company that's already established, in the past his companies were created from scratch and then built through acquisitions. Jacobs has a history of starting a company and then creating a billion dollars in revenue within a short period of time, less than 5 years. I believe the stage is set and because of this company's low valuation it's presenting unprecedented value. Jacobs has already stated that he intends to build a billion dollar company through acquisitions and cold starts and in his first three months he's already hired a dream team of executives that have extensive experience within the industry. I believe this will be his most successful company to date and that XPO is the best kept secret within the market. To read more on the company's business plan and its growth strategy click here.

With small cap stocks I want an established company with a solid product or service in an industry that I believe will grow. I have already mentioned two stocks that are somewhat unknown with significant upside but another investment that I believe will return large gains in the next five years in energy. Because of government focus and consumer's disapproval of high gasoline prices I believe the next bubble will be in some form of alternative energy. And there are a large number of small-cap efficiently ran companies that would make great investments over the next five years. The most obvious would be natural gas as Americans try to cut dependency on foreign supply and for this reason I believe that Royale Energy (NASDAQ:ROYL) would make a great long-term investment. However, I am also quite bullish on ethanol because of its cost cutting affects and more specifically Pacific Ethanol (NASDAQ:PEIX).

There has been a lot of optimism surrounding Royale Energy over the last month as its supply of gas continues to grow. The company operates in a large amount of acreage and has been successful at finding and securing natural gas. The company's most recent discovery in the Sacramento Basin has increased production and the company's now operating very aggressively to capitalize on its various discoveries. The company's Goddard wells have already produced over 2 million cubic ft to date and should begin selling next week. The stock's increased by 38% over the last month and is now trading with a market cap of $43.5 million. Therefore I believe the company's supply presents an opportunity for investors to capitalize on a small-cap stock with large growth potential. I believe that ROYL is the best small-cap natural gas play within the market and if the commodity were to rise it could result in ROYL becoming a very large company.

Ethanol is highly debated with investors either extremely bullish or bearish on its future potential. However, Pacific Ethanol is showing nothing but promise and after record earnings investors have been snatching up shares for the last month, resulting in a 211% gain. I am particularly impressed with the company's 9 consecutive quarters of increasing its total number of gallons sold. During the last quarter the company posted an all-time best with 122.6 million gallons sold, an increase of 71% year-over-year. With growth such as this it's easy to see why investors are so excited, and since the company's showing no signs of slowing growth I believe it will continue to expand and increase sales over the next five years. Much like my belief that the transportation brokerage industry will grow I believe that the demand for ethanol will rise as well. Global demand for corn-based biofuels is at an all-time high and the prices for ethanol have increased by 20%. Ethanol makes the air cleaner and gas cheaper therefore I wouldn't be surprised to see a political push within the next few years which could increase the growth of ethanol even faster which would directly affect the growth of PEIX.

The stocks I've discussed are my personal favorite small-cap stocks. However, there are several good small-cap stocks being traded that have serious upside potential. The important point to remember is that there are too many good stocks with upside potential to buy investments with unproven speculation. Before buying a stock I make sure it's profitable, has a solid product, and is operating in a growing segment. I believe that each of the stocks that I've mentioned meet the criteria and will post incredible gains over the next few years.

Disclosure: I am long XPO, ACUR. As with any investment, due diligence is required. The opinions in this article are not intended to be used to make a particular investment or follow a particular strategy but rather informational purposes only.