Posted on October 10, 2011 by David Laidlaw
Most advisors manage their funds using what is a called a “Core/Satellite” approach in industry jargon. This investment process involves investing the bulk of a client’s assets in traditional assets such as blue chip domestic stocks, large cap foreign stocks and bonds. A minority of assets are then invested in various satellites. These satellites include a very wide array of investments including: foreign and domestic small/micro capitalization stocks, commodities, hedge funds, real estate, derivatives, managed futures and other more esoteric investments.
While advisors still allocate a bulk of the assets to the core, many professionals spend the majority of their time uncovering asset managers and investment products in the satellite category. At its base, investing is a numbers game; however, clients are often ultimately sold on the story: whether an investment has a compelling narrative. Satellite investments are typically made in markets which are far less liquid with lower levels of capacity. Given the underlying limited supply, the prices of these satellite investments get pushed up higher limiting the potential for long-term returns.
On the other hand, the core portfolio receives very little attention. Advisors will either invest passively in index funds or actively where managers are trying to perform better than their appropriate benchmarks. Given its boring status, core investments receive smaller allocations than they would receive based on the relative size of the market compared to all of the satellite options. This underinvestment pushes the prices down, especially in core common stock holdings. Therefore, the core is often a much more attractive investment since it is possible to get higher returns for less risk than in the satellite options.
Aside from being undervalued as a whole, core common stock investments are also treated as commodity (read interchangeable, not oil or gold) holdings with little that differentiates how their businesses are valued relative to other stocks in the core. Many stocks with widely different business models, growth potential and risk profiles get slapped with the same valuation even though they should be valued much differently. For example,Google and Yahoo are selling for roughly the same amount on a Price to Earnings basis even though Google is growing faster and has a much stronger cash position and market position.
Examples such as the above are the rule and not the exception. Core common stocks are viewed as homogenous. Core stocks are generally undervalued and there are incredible bargains within this universe. While investors have achieved modest returns over the past decade by avoiding the most speculative and high-priced stocks, the future should provide better returns since valuations are so depressed relative to the internal returns companies are generating.