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Your instant 3-share small cap portfolio

A sustained low interest rate environment has a number of effects on equities. Most notably, the comparative attractiveness of dividend yields.

In 2013, dividend plays reigned supreme and blue chips like Wesfarmers (ASX: WES) and Telstra (ASX: TLS) outperformed the market. The strong rise of many blue chip stocks has prompted some investors to believe that these market darlings are overvalued.

Now, we’re likely to witness investors take on more risk for more reward and diversify into smaller stocks. Here’s an example. Since Perpetual (ASX: PPT) started its microcap fund in September with just $5 million under management, the fund has returned approximately 20% and has ballooned to nearly $50 million. That has all happened while the S&P/ASX Small Ordinaries Index (ASX: XSO) has fallen 2%.

In my opinion, 2014 is likely to show more of the same. For 2013, the Small Ordinaries Index will finish around 7% lower, yet will continue to pay strong dividends and grow earnings into 2014. Now could be the perfect time to pick up one of the following three stocks.

Global Health (ASX: GLH)

In 2013, this e-health solutions provider has increased EBITDA 294% to $1.765 million and its share price returned nearly 700%, yet it still trades on a modest earnings multiple of eight. It is an $11 million software development small-cap which seeks to connect medical professionals from all walks of life. Management are predicting EPS growth of 25% in FY14.

Yellow Brick Road (ASX: YBR)

Just like investors have enjoyed the run-up in the stock market, so to have fund managers and financial advisors. Yellow Brick Road is a small financial services provider. It has a market capitalisation of $105 million, is partially owned by Channel 9, Mark Bouris and senior management. Although it is yet to turn a profit, in 2013 group revenue grew by 68% to $24.88 million, which included mortgage revenue up 118%, wealth management revenue up 217% and general insurance revenue up 29%.

Cash Converters (ASX: CCV)

With interest rates set to stay low in 2014, a solid income and growth story might be what you’re after. Cash Converters is cheap. Trading on 9.7 times trailing earnings and a dividend yield of 5% fully franked, it’s one stock I’m continuing to add to my portfolio. It’s a well-established business here in Australia and in the UK. Morningstar are forecasting earnings to be flat in the next year (as a result of new consumer lending laws) but will grow beyond 2014.

Foolish takeaway

The number one rule of investing is: “Buy in troughs and sell at the peaks.” It can be hard to predict the troughs and even harder to determine the peaks but buying good stocks when they’re cheap and holding for the long term is one way to tap into the upward ebb and flow of the stock market.

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Motley Fool Contributor Owen Raszkiewicz owns shares in Cash Converters and Yellow Brick Road. 

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