The words "market" and "economy" are often used synonymously, yet they're not one and the same. The U.S. economy appears to be sputtering along, while the stock market is going full speed ahead. It makes an impending correction look ever more likely, which makes wary investors move to bonds. This leaves some investors searching for other investment strategies that may not be the most traditional. One strategy is referred to as the "core and satellite" portfolio.
The goal of this strategy is to create a portfolio that outperforms the broader market in the long term while using short-term market opportunities to dampen the effect of market fluctuations.
Core investments are long-term in nature. They spread across a range of sectors and asset types, from basic materials to financial institutions and from equities to bonds and REITs. The satellite portion of the strategy seeks out specifically targeted growth opportunities that can round out the core of your portfolio.
The percentage of the portfolio you allocate to core investments can be as high as 90% of your total assets. You want a collection of broad stocks, ETFs, or index funds. Be sure to match the goals of the fund with your own investment time horizon and look for funds with an expense ratio less than 1% to keep costs down over the long term.
The satellite portion can represent as much as 40% of your portfolio. Your investment strategy is twofold: pursue greater returns over the long term and build a hedge against market volatility. Specifically, you're looking for asset classes with lower correlations than traditional assets, e.g., emerging markets, small-cap equity funds, real estate, or commodities. Individual stock picks also fall into this category.
Monitoring your portfolio
The perfect balance between core and satellite depends on your investment risk tolerance. In general, the longer your time horizon is, the more risk you can afford to take on. And the larger the satellite portion of your portfolio is, the more time you will need to spend managing your holdings. Although your satellite investments will require more time and attention, they should collectively outperform your core portfolio in the long run.
Satellite investments aim to achieve superior returns. One approach is to look at analysts' five-year growth projections. According to Morningstar, the sector with the highest five-year EPS growth projection is transportation at 17.6%. However, paper and paper products is the top industry by the same measure at 48.7%, so let's drill down into the paper industry.
Two companies in the paper industry with strong growth are Neenah Paper, Inc. (NYSE:NP) and P.H. Glatfelter Company (NYSE:GLT). Both companies offer a dividend and have raced ahead of the broader market over the past five years:
Neenah is a small paper company with a market capitalization of $827 million. The company is setting 52 week highs on strong earnings. Earnings were up 30% in the fourth quarter compared to last year, and strong cash flow allowed the company to announce a 20% quarterly dividend increase to $0.24 per share. Neenah attributes its growth to a profitable niche in the filtration, specialty backings, and premium papers markets. Operating income increased 19% in 2013, and diluted EPS from continuing operations increased 23%.
"Our teams improved efficiencies," said CEO John O'Donnell, "achieving double-digit operating margins and an increased return on capital, while generating $55 million in free cash flow."
Glatfelter is a $1.3 billion company that makes specialty papers and fiber-based engineered materials. Glatfelter has a dividend yield of 1.43% and recently announced a quarterly increase of 10% to $0.11. The company reported record sales of $1.7 billion in 2013 and EPS of $1.52, compared with $1.36 in 2012. Glatfelter attributes its success to both organic and acquisition growth and plans to invest $50 million in a capacity expansion project for composite fibers.
Both companies have returned more than 65% over the past year, and they look poised to repeat that performance in 2014.
What's more important about this exercise is not the investment pick but the process of selection. In a nutshell, you want to look for low-risk, well-managed investments for the core of your portfolio and higher-return investments for the satellite portion.
Please keep in mind that all investments involve a certain degree of risk, including a complete loss of principal. Don't invest money that you can't live without.
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