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Remain diversified while concentrating on your top stock ideas

An increasingly popular strategy is the core and satellite approach to portfolio construction. The bulk of your portfolio, say 80%, is invested in a passive or index tracker funds with the remaining 20% invested in three or four individual stocks.

The aim is to have the combination of the core index and the satellite shares deliver returns greater than if you just had 100% index exposure. While at the same time providing a safety net in that if one of satellite investments crashes and burns it shouldn’t drag down your overall performance too drastically.

Naturally, for this strategy to be successful you have to select stocks that will outperform the market – more on that later.

This strategy allows you to invest in the few companies you have strong belief in, while still remaining diversified via the core. The aim is to get some of the benefits of a concentrated portfolio, without taking on as much downside risk. The other key advantage is this core and satellite strategy is a very low cost approach.

Building our solid core

Your core needs to be broadly diversified and very low cost. An ETF like the Vanguard Australian Shares Index ETF (VAS) or the SPDR S&P/ASX 200 (STW) will give you diversified exposure to the broad Australian equity market, all at a low cost.

You can even split the 80% core index into 40% Australian equities and 40% International stocks by adding a broad international focused ETF. The Vanguard All World ex US Share Index (VEU) or the iShares MSCI EAFE (IVE) could fill that role. These ETF’s should give a good solid core that will match the index return and provide good diversification while also keeping expenses low.

Getting the Satellites into orbit

As we all know, the top 200 stocks have an army of analysts and fund managers monitoring them continuously. Therefore, it’s doubtful your stockbroker will provide any new or remarkable insights that will give you a consistent advantage over others. History tells us it is very hard to outperform the market on a long term basis.

It’s also doubtful you will be able to uncover anything that analysts have missed since you won’t be doing it as your full time job. However, once we move away from BHP, CBA, TLS and the top 300 stocks the possibility of finding a little gem of a stock that has yet to be uncovered by the market increases.

By finding three or four of these gems, adding them to the portfolio and combining their returns with the return from the core part, we should be able to outperform the market and probably most fund managers!

It is also much easier to understand three or four small companies than the top 300 stocks on the ASX – so we let the ETF’s take care of them.

Small Caps can make great satellites

A recent report from S&P showed that 75% of small cap fund manager’s outperformed the market. And if the majority of them can do so, then so can we! Researching their top holdings (usually via their website) can provide some good ideas for further research.

Small Caps are also generally easier to understand as they usually have only one product or service as opposed to a big conglomerate like Wesfarmers Ltd. (ASX:WES) which has multiple businesses. Remember the golden rule of investing is not to invest in anything you don’t fully understand.

I tend to look for stocks that are already paying regular fully franked dividends as it is an indication that the business is through the hard start up phase, profitable and most likely to have a good operating cash flow.

A good return on equity figure is also a good indicator that the business is continuing to grow. Companies like Reckon Ltd. (ASX:RKN) and Corporate Travel Management (ASX:CTD) fit the bill here. Both have strong business models and while not micro cap stocks they are still small enough to be off the radar of most of the big players.

If you are looking satellite stocks you can bet on now, readers need look no further than The Motley Fool’s Top Stock For 2012Click here now to request this special report, while it’s still free and available.

Fool contributor Mark Tobin does not own any of the shares mentioned in the above article. Mark works for Wilson Asset Management, and that firm or its clients may own any of the shares mentioned above. These positions can change at any time. The Motley Fool’s purpose is to educate, amuse and enrich investors.  This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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