Ok, so here's what i have come up with for your delema
First of all, use grub, it wont have problems performing, on the USB drive, just make a small ext4 partition for grub and all your favorite magical boot files (like 35m would do, actually even less, that depends on your kernel), the rest you can mount as squash, and consider even making a small ram-disk partition for home directories and whatnot. You can probably make a swap-less boot, and try to maximize your kernel to be as lean as possible, but be able to support as much hardware (reasonably) as possible through the use of modules (remember anything that is not needed from the get-go, should be modularized)...
I think i would start with:
Partitioning the drive
setting up the ext4 partition for grub boot
creating a temporary working directory (ies) to be later converted to squashfs partition
creating your distro, installing kernel, drivers, what have you, making sure it all works (by booting using that kernel, and then chrooting into it) installing/testing software, etc.
Finally cleaning up all the logs, documentation (that takes up tons of space), finally squashing the system and dding it to a squash partition on your thumb drive. (remember you will need usb support built in, lzma, and squasfs as well as ext4 built inito the kenrel)
Finally, ofcourse testing all that
Hope some of this helps
here are some random references:
USB boot on Linux
Linux Convert ext3 to ext4 File system
How to make a live CD/DVD from your harddisk installation - Ubuntu Forums
SquashFS HOWTO
within those, you should get a really great idea on how you will go about building your lfs on usb system...
enjoy
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