This Is How A Dividend Growth Investor Can Use The Core-Satellite Model

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Includes: OHI, SCHD
by: Ville Peltonen

Summary

Core-satellite model consists of a passive portion and an active portion of a portfolio.

Typically the core consists of an index fund and the satellite consists of individual stocks.

DGIs can use a dividend ETF as the core and pick individual stocks from the dips.

The core-satellite is a method used when investors seek a risk-controlled portfolio with the possibility of taking advantage of temporary dips in the market, as was the case at the beginning of the year. Typically the core-satellite portfolio is constructed using an index fund as the core. This core might be 50% of the whole portfolio's value. The idea of the core is to be a passive portion of the portfolio that is not traded at all. Around that solid low-risk core the rest of the portfolio can be built using individual actively managed stocks that are called "the satellites". There is no limitation on the amount of individual stocks, so it can be one stock or 50 stocks. This strategy provides "time in" the market with the core portion, as well as "timing" the market with the satellites.

A dividend growth investor can also use this model to build a solid DGI portfolio. The core can be built using a basic index fund from Vanguard or any other provider that pays a dividend every quarter or even every month. A true DGI can also use a fund or ETF that consists of dividend growing companies and my pick for a core ETF is Schwab US Dividend Equity ETF (NYSE: SCHD). This ETF provides a variety of the best dividend growth stocks in the world with a very low fee of 0.07%. The index fund or ETF that is selected as the core will provide the basis of the portfolio and will also pay a dividend. The core will be low on fees and also low on risk. Not to mention well diversified. This core should act as a solid foundation that helps you sleep at night because of the low volatility and broad diversification. The core can also be made up entirely of ETFs that reinvest dividends, so taxes for dividends can be avoided.

The so-called problem with index investing is that you are not able to take advantage of the temporary dips in the market or mainly in individual sectors or even companies. A scenario like we had at the beginning of the year when stock prices came down almost across the board in whole market is a situation where an index investor can take an advantage. But when the dip happens in a particular sector like we saw in the energy sector, it doesn't really do much for index investors.

There are always good opportunities in every sector when we see scenarios like we saw last year. That is an opportunity to pick good companies at attractive prices for the satellite portion of the portfolio. I see these opportunities as the best chances for bargains as great companies are dragged down by the whole industry. You can also find opportunities like these when one company reports weak results and the market thinks that other companies in the same industry are having the same problems. An investor just has to know if the problems are entity-specific or if it is something that affects all companies in the industry. It helps to have a watch list of stocks that you are familiar with so you know when the dips are just because Mr. Market is being moody or scared, or if there's a more specific, endemic issue at play.

So, the satellite portion of the portfolio can consist of individual stocks bought from temporary dips at attractive prices. These satellites can be sold when they bounce back or become overvalued for some reason. Those gains can then be used to buy more satellites from dips or to strengthen the core by buying more of the core index fund.

A good example of a buying opportunity was when HCP Inc.'s (NYSE: HCP) weak guidance sent the whole Healthcare REIT sector tumbling, with 5% drops in solid companies like Omega Healthcare Industries (NYSE: OHI). However, HCP's problems had absolutely no impact on Omega Healthcare. In other words, HCP's issues were basically entity-specific, but they took down the entire sector in sympathy. We saw a chance to buy OHI at $27, then it rebounded to $33 in a short period of time. A core-satellite model investor could have bought OHI at this temporary dip and keep it as a satellite stock collecting dividends or take the short-term gain by selling it when the price came back up. For example, you had put OHI in your watch list for possible satellites and after analyzing the stock ended up with a valuation of $31. Now the situation occurred where the price went down to $27 and you come to the conclusion that this drop is not justified, so you take advantage of the situation and buy the stock as a satellite. Now you would have ended up with a satellite bought at a price under your estimated valuation that pays a hefty dividend. You could hold on to the stock or you could sell it when you think it becomes overvalued. In hindsight this was a perfect example of an opportunity to add a satellite to the core-satellite portfolio. Opportunities like these come across once in a while and they truly are great opportunities if you follow the core-satellite model.

Following the core-satellite model does not mean that you absolutely have to trade with all of your satellite stocks. It only gives you the opportunity to separate the buy-and-hold portion of your portfolio from the chance to trade in and out of individual stocks. There is always the possibility to do no trading even with the satellites. You can just pick individual stocks to go along with the ETF that forms the core of your portfolio. What this strategy does is that it allows you to capitalize when individual stock are overvalued and others are undervalued. Have you ever been in a situation when you have an overvalued stock in your portfolio and a great opportunity comes along to buy a stock that is massively undervalued for a brief moment, but you don't have any funds to allocate? Sell high and buy low, but sit tight on that core of the portfolio.

As I have already mentioned, the strength for this strategy comes from the ability to take advantage of temporary dips in individual stocks. You are able to diversify your portfolio without giving up the potential for higher returns. Being solely an index investor, you will not have those opportunities as you are also buying the possibly overvalued stocks when buying an index fund. Having a core on your portfolio reduces volatility and reduces the risk of making wrong choices if you're solely buying individual stocks. The weakness of the strategy is taxation when selling and buying the satellites, as the more you do it, the more you pay in taxes for capital gains and in fees. You might also end up with a little bit lower yield stemming from the core portion.

Tracking the performance of a core-satellite portfolio is basically up to the individual investor and what you want to choose as a benchmark. I'll explain some examples of how it can be done. You can measure the average return and the yield of the two portions of your portfolio and see which one has done better, the core or the satellite. This measurement will help you to decide in which portion you should allocate your funds. Other option is to select an index or some other benchmark that you compare the performance of your core-satellite portfolio.

In my portfolio, I have a core portion that is 25% of the portfolio value. I might increase that portion to approximately 50% with a few different ETFs like the SCHD. However, I do not trade with the satellite components, unless there is a significant reason for it, like a change in the dividend policy. One of my main reasons to use the core-satellite model is the heavy taxation and fees in my native country, Finland, and also diversification.

Disclosure: I am/we are long OHI.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.