Your Core Portfolio: Small-Cap Value Stocks

by Lawrence Meyers | August 23, 2013 6:30 am

Today, we continue to construct your “core portfolio.” As a reminder, the concept of the core portfolio is to create a diversified list of holdings that are designed to last for years.

Of course, you should still rebalance your portfolio — which you can see below, along with hyperlinks to the parts of the core portfolio I’ve already covered — every six months or so, particularly as stocks shift into a different asset class. One example: When a small-cap pick becomes a ten-bagger!

And that brings us to my favorite asset class: small-cap value stocks. These stocks should make up around 4% of your holdings.

Asset Allocation Asset Allocation
Large-Cap Growth[1] 15% Options 5%
Large-Cap Value[2] 15% Midcap Growth[3] 4%
International/Emerging Market 15% Midcap Value[4] 4%
Income-Driven 14% Small-Cap Growth[5] 4%
Special Situations 10% Small-Cap Value 4%
Swing Trades 10%

I’m partial to small-cap value stocks because they tend to be in businesses that people don’t like or don’t understand, and they have the best chance of becoming multi-baggers.

Of course, there’s two sides to that coin. A common tale of woe for small-cap value stocks is selling too soon. The classic example is Jos. A Bank Clothiers (JOSB[6]), which I discovered while walking in Manhattan one day in early 2001. I bought the stock at $5 and sold it at $8, thinking I was a genius. But when a story is good, it’s good. Had I held, I would have made far more.

Anyways, what’s past is past … and now it’s time to pick some new names. The two main things I like in small-cap value stocks are a market cap under $3 billion and a PEG Ratio under 1.

To start, I’m anchoring this asset class with an exchange-traded fund … as always. I like the iShares Russell 2000 Value Index (IWN[7]). The top 10 holdings, which make up about 4% of the ETF, are mostly obscure names like the bank Firstmerit Corp. (FMER[8]) and specialty chemical company Axaill Corp. (AXLL[9]).

Next up, I always turbocharge each asset class with additional holdings. Anyone who follows my columns even relatively regularly already know my three favorite stocks at the moment are pawn-shop owner EZCorp (EZPW[10]) and debt collection stocks Portfolio Recovery Associates  (PRAA[11]) and Encore Capital Group (ECPG[12]).

These are also my first picks for our small-cap value stocks. The former trades at roughly half its fair value[13], while the last two collect three to five times what they pay for bad debt[14].

Another good pick is the small-cap value space is actually in the hotel REIT sector. I’ve followed Ashford Hospitality Trust (AHT[15]) since its 2003 IPO. Three things to like: Ashford dividend yields 4.1%, its CEO has 23 years experience in hotels and the company has always deployed its capital prudently and with solid returns.

Last but not least, I also like Dorman Products (DORM[16]) — a nice, boring company that operates in the high-margin field of automotive replacement parts. It’s PEG ratio is a bit over 1, but I forgive it because it has solid cash flow and no debt.

That’s all for this week, folks … but stay tuned! Next week, I’ll get into income plays.

As of this writing, Lawrence Meyers owned shares of IWN, EZPW, PRAA, ECPG and AHT.

  1. Large-Cap Growth:
  2. Large-Cap Value:
  3. Midcap Growth:
  4. Midcap Value:
  5. Small-Cap Growth:
  6. JOSB:
  7. IWN:
  8. FMER:
  9. AXLL:
  10. EZPW:
  11. PRAA:
  12. ECPG:
  13. trades at roughly half its fair value:
  14. what they pay for bad debt:
  15. AHT:
  16. DORM:

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