3 Small Caps for My “Dream Portfolio”

For more than a century now, small-cap stocks have outperformed large caps quite reliably. Sure, some years are better than others and some years are downright bad. But throughout the past 80 years, small caps have averaged an annual gain of 11.0%, while large caps have averaged an annual gain of only 9.1%.

Although a difference of less than two percentage points a year seems insignificant, those nickels and dimes can add up to become dollars in a few decades.

Moral of the story: Own small caps whenever you own large caps.

In fact, sometimes the more obscure the small cap, the better. While companies like Vonage (NYSE: VG) or Take-Two Interactive (Nasdaq: TTWO) technically qualify as small caps, they’re also high-profile names. As such, they both draw a lot of attention, which in turn means it’s very unlikely an investor would ever find one of them to be undervalued.

An off-the-radar company with a promising business, however, may well be underappreciated by the market for a period of time, allowing an astute investor a great window of opportunity.

Take Nordson Corp. (Nasdaq: NDSN) for instance. This machinery stock is anything but a household name; it makes high-precision dispensers used to apply adhesives, sealants and coatings for several types of products, ranging from baby diapers, to the food service industry products, to electronic and construction materials.

Yes, mulling an investment in Nordson is about a notch above watching paint dry, but it’s a sneaky stock like this — which is so “behind the scenes” you don’t even think of it — that can post triple-digit gains on the heels of several big quarterly EPS (earnings per share) increases, yet go completely unnoticed by the media.

Well as it turns out, Nordson just completed its most profitable year ever, turning in per-share earnings of $4.62 for 2010. That’s well above 2009’s figure, and 31% better than its peak earnings in 2008. This year’s bottom line is expected to be nearly 13% better than last year’s, but considering we’ve seen the company top estimates in 12 of the past 16 quarters, analysts may still be underestimating Nordson. 

GT Solar International (Nasdaq: SOLR), on the flipside, isn’t mired by anonymity. It may be a victim of guilt by association though, which is where the opportunity lies for the patient investor.

Solar panel makers, like the solar power industry itself, have been all over the map in the past four years.Some of these companies are profitable; many are not. And, the future of the government subsidies that the industry desperately needs has been in question for too long.

All that noise has distracted investors from one key fact about GT Solar — it’s been reliably growing profits since 2009, regardless of political winds of change and the volatile price of oil. Eventually, the market will figure it out and start to realize that its forward-looking price-to-earnings (P/E) ratio of 8.3 isn’t just wishful thinking.

And finally, there’s a good chance investors may be using a Plantronics (NYSE: PLT) product without even realizing it. The company manufactures a variety of mobile phone, VOIP (Voice Over Internet Protocol) and music headsets, including several Bluetooth-enabled devices. In fact, Plantronics sells more than $600 million worth of goods a year. Not too many people notice though, as the iPhone or the VOIP service or album being enjoyed gets all the attention, while the simple Plantronics hardware making it happen is taken for granted.

The rapid proliferation of smartphones, more VOIP options and Bluetooth hardware have fostered so much of a market for Plantronics that the company is expected to see record-breaking profits in 2011. It already dominates the market, but is on pace to penetrate it even further.

In the case of Plantronics and Nordsen, both companies are the indirect and low-profile beneficiaries of the economic recovery. GT Solar is anything but low-profile, but it faces an equally-difficult environment of doubt. In all three cases though, the companies have more than proven their mettle to those who are looking. The rest of the market will get it sooner or later.

Action to Take –> To be clear, three stocks don’t make up a total portfolio. But three great small-cap stocks are a solid start toward building the various pieces of a solid portfolio.

As always, regular monitoring of these three names — or any of your positions for that matter — is prudent, since changes take shape over time. Right now, Nordson, GT Solar, and Plantronics are in the right place at the right time, leading their respective growing markets and waiting for everyone else to notice.

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