Extreme expectations

According to Roxburgh Securities authorised representative Philip Carman, a portfolio management system he has developed over the past 12 months has the capacity to provoke stimulating debate about portfolio construction.

“What is it? It’s a risk-controlled strategy for an investment portfolio,” Carman explains.

“It’s easily understood and acted upon. Strategies are all very well, but the real issue is client expectations. An investor expects something and the adviser has to deliver. This identifies the client’s expectations.”

Here’s how it works: A model Carman portfolio has 30 per cent invested in growth assets and 70 per cent in liquid assets. (Carman points out that the type of growth assets in the 30 per cent may differ depending on the cycle — at the moment it’s direct equities.)

Why only 30 per cent?

“Because it seems to me that the big risk occurs when you have too much exposure to assets over which you have no control,” Carman says.

“Better to have concentrated and identifiable risk, managed intensively. With only 30 per cent in stocks, there’s limited downside.”

His insistence on keeping growth assets on a short leash sets Carman apart from many other financial planners. Despite the stock market downturn, the equities portion of most client portfolios would still comprise more than 30 per cent of total investments.

Carman also criticises orthodox portfolio construction for its insistence on diversification and managing against a benchmark.

“It gives people a false sense of security and creates mediocrity. Also, classic portfolio theory doesn’t quantify the potential for loss. And its emphasis on diversification means you’re totally dependent on managed funds.”

Carman maintains a list of about 25 recommended stocks. AGL, for example, he recommends at $9.60 or lower, BankWest at $4.00 or lower, GWA at $2.40 or lower, Hardman Resources at 65 cents or lower, Newcrest at $6.30 or lower, SimsMetal at $7.00 or lower, Telstra at $5.00 or lower and WA Newspapers at $5.00 or lower.

In addition, he has a watch list of stocks whose share prices are not yet low enough to buy. In November it included Blackmores, Tapcorp Holdings, and Woodside. At present, he does not recommend managed funds.

A total portfolio worth $500,000 would include only $150,000 worth of shares because of Carman’s 30 per cent limit on growth assets. That means, he says, that such a client would hold only about seven or eight stocks.

Once the stocks are selected, with advice from Carman, the client sets sell points on each stock. This is a key part of the process, because it’s where clients get to understand their own risk tolerance.

Carman’s methodology divides stocks into two categories — core investment stocks, such as Telstra and WA Newspapers, and higher volatility stocks.

He imposes sell disciplines on both the upside and downside as follows: He recommends that clients sell out of stocks in the first category once the price declines by 20 per cent, and he recommends they sell part of their holding if the price rises by 25 per cent. The client may in fact decide to sell on a smaller decline and/or rise. The portion the client sells on the upside is also variable — Carman recommends 40, 50 or 60 per cent. The higher the tolerance for risk, the smaller the sale percentage.

On higher volatility stocks, Carman recommends selling 100 per cent after a 30 per cent decline, and selling a portion of the holding after a 40 per cent rise.

“What we want to avoid is getting into a holding and hoping pattern,” Carman says, explaining his robust approach to selling.

“It’s hard to crystallise losses, but I think hope and investment have nothing to do with each other.”

It is the sales on the downside that draw the strongest criticism from commentators.

“If you believe something is of value, why would you pull out when it gets cheaper?” asks Dominic McCormick, chief investment officer at Select Asset Management.

“You want to avoid a huge loss — but 30 per cent could be pretty big. I’m not saying buy and hold is the only way to go, but with this, you could end up continually taking losses, particularly in a bear market.”

McCormick was fairly supportive about the gradual sell discipline on the upside: “You don’t want to be so exposed that your portfolio is too dependent on one stock — I agree with that, although this may be a bit rigid.”

Meanwhile, a stock researcher at one of the asset consultants commented: “A system like this is usually based on technical lines of support for the stock. But in this system, each person sets their own technical support. That’s a conceptual difficulty.”

Most of the researchers agreed that the system had the advantage of taking the heat out of individual decisions, but in doing so, it substitutes a rigid system for individual judgment.

Then there’s the important matter of picking stocks.

Carman chooses his recommended list on the basis of sustainable earnings.

“I use everyone’s research. Income is what everyone’s looking for now —wasgrowth,isvalue,will beincome, in my opinion.”

His selections are based on his own observations, occasional company interviews, and a review of the consensus of stockbroker research.

“All the stocks, with the exception of two gold stocks and the oil explorer Hardman, are involved in the manufacture and/or distribution of fairly basic consumer goods, services or commodities,” Carman says.

“All of these core stocks pay dividends that are higher than bank interest rates and most have a history of generating pretty strong profits for shareholders.”

Carman estimates that by using his system over the past year, total performance would have been between 10 and 11 per cent. That’s made up of about 4.7 per cent income from both shares and liquids, and, best result, about six per cent capital growth.

These are theoretical performance figures. Actual figures are not possible to calculate since Carman has been slowly phasing the system in for his 75 clients with active portfolios over the last 12 months.

Performance figures are before tax and stockbroking fees — both of which could be quite high in a volatile market. They are also before Carman’s management fee of around one per cent.

What do the critics have to say about the stock selection?

One head of research at a large fund manager commented that the small number of stocks in each investor’s portfolio represents a very high stock-specific risk. “If I was a client, I’d be interested in his track record as a stock picker. This kind of portfolio is all about stock picking.”

McCormick characterised Carman’s approach as an absolute return focus. “I’m always supportive of ways of looking at and ways of developing absolute return portfolios. Without that we’ll never get away from hugging the index. But you’ll never get away from market risk.”

Without closer knowledge of the system, McCormick was unable to comment on whether Carman’s methodology was an efficient way to manage market risk.

All the researchers were wary of the lack of industry and international diversification in Carman’s stock selections, and one commented that with an absolute return fund, as opposed to the relative return of a diversified fund, market timing becomes crucial.

Carman acknowledges these concerns, but he insists that the issue many of them don’t address is unique to advisers — how to manage the relationship with the client.

Most advisers manage the fear and greed issue by investing clients in managed funds, thereby allowing the fund manager to take on some of the pressure. But for those with clients in direct stocks, setting clear sell guidelines upfront may be a practical way of capturing gains while reducing downside risk.