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A 2-to-1 Rule for These 3 Small-Cap Stocks

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There are absurdly attractive valuations broadly across the TSX financial sector. With so many apparent choices, it’s good to have a procurement plan, like this two-step procedure to gain exposure to one of the historically strongest sectors.

Step one

Pick your favourite among the Big Five banks. There are a lot of opinions on which Big Five bank is best. All will benefit from the interest rate tailwind. All will also experience pain during economic downturns. You basically pick the poison you can live with, such as the one with the heaviest U.S. exposure, heaviest emerging markets exposure, or strongest link with Canadian real estate. Only a small amount of research by a diligent do-it-yourself investor will narrow down choices. Here’s where your gut instinct will serve you well, so long as you are willing to hold shares for 10 years and beyond.

A nearly-zero-effort approach is to search for “Canadian financial ETFs” and pick from a handful of basket style investment vehicles.

Step one is no sweat to complete.

Step two

Now is your chance to spruce up your financial holdings with some solid but smaller and slightly riskier stocks that either pay fatter dividends or are expected to grow more rapidly than the Big Five. The key rule to step two — one that I follow myself — is to not overload your holdings with small caps.

A decent rule of thumb

Buy twice as much at step one as you do for step two, continuing the process each year and picking from among these three choices.

An investment in this small-cap VersaBank (TSX:VB) is a bet on the rise of online banking, and I give Fool contributor Mat Litalien full credit for delving into the VersaBank weeds. Admittedly, operating exclusively as online bank exposes this company to greater cybersecurity risk compared to a more diverse bank. An investor should be prepared for share price pullbacks that could be large in the future, like the 20% price drop earlier in 2018, which, unfortunately, is consistent with rockier growth stocks.

An income investment that is lower risk, despite the small-cap status, would be Timbercreek Financial (TSX:TF). Here, you’ll find lower volatility, lower trading volumes, exposure to real estate, and a sizable 7.6% dividend yield. Trading in a range above $9 a share has kept this stock reasonably cheap with forward earnings multiple of 12.

The final option to consider here offers a combination of growth plus the 2% dividend income by buying shares of Goeasy (TSX:GSY). From 2018 to 2019, earnings are estimated to rise a whopping 56%. No big bank offers such growth! But before getting too excited, the stock plunged 16% in one trading day on November 8, 2018 — a poignant example of why you don’t want to overload your portfolio with one stock.

Take-home message

If you are still part of this thought experiment, then it’s time to consider implementing. Splitting $3,000 in a 2:1 ratio is enough to start. Watch the small cap more closely and feel free to ignore the big bank pick. This time-efficient and simple rule ensures you’re building wealth with a risk level most would be comfortable with.

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Fool contributor Brad Macintosh has no position in any of the stocks mentioned.

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