Taking Stock 31 January 2012

As public opinion polls have sometimes demonstrated, the status of property landlords, property developers and property financiers is often about the equal of people who exploit the infirm, the trusting, or the very young.

Not many people who invested in the 1980s will forget various public company figureheads, whose property values lacked integrity, and most who recall the last decade will have etched in their minds names like Finnigan, Serepisos, Henderson, Podmore, Somers-Edgar, McKenna, Hotchin, Watson, Muir, Petricevic, Reeves, Tallentire, Butler, Lindale, Bublitz, Fitzgerald, McLeod, Bosworth, Thompson etc. On these people opinions will vary, some perhaps sharpened by investment losses.

Business failures, perhaps not explained, or explanations not accepted, do colour the public view of all those linked to high risk/high return activities, especially when the public have so often been granted the high risk, but never offered commensurate returns.

There is many a gentleman’s club or prestigious golf club that has declined membership applications from those in the property sector, however much “wealth” the applicant has alleged, just as they did with Frank Renouf in the 1970s and 80s.

So it was a treat and a privilege to hear the many and real tributes paid to the late Bruce Mansell, at his funeral in Paraparaumu last week. Some property people are indeed admired.

Mansell would not have been known outside the Kapiti Coast. He was a private person, with a family focus, no appetite for private jets, call girls, media attention or political leverage. Perhaps he was also a workaholic. He was at his desk when he died, aged 74.

Bruce Mansell’s family trust, which he chaired, had majority control of Coastlands, perhaps a unique business in New Zealand, controlling the retail sector in a town of nearly 30,000 people.

Coastlands, one of the original shopping centres to open on Saturdays (in the 1960s), is more than just a shopping centre in this area.

It effectively is the town centre, and houses banks, supermarkets, fast food chains, medical centres, retail shops, a garden centre, a gymnasium, a petrol station, the local movie theatres, and car parking for many.

It is beside State Highway One, with egress, and opposite the main railway trunk-line, the railway station, the council headquarters, and the police station.

To my knowledge no other town of 30,000 in New Zealand has such a dominant property owner.

Yet at his funeral, Bruce Mansell attracted a wide range of fulsome tributes, ranging from the Mayoress, to a most eloquent and dignified Maori Elder, representing a tribe which was in partnership with Mansell as a land-owner and developer, and to his Rotary Club, where he had been honoured for his community service.

The Maori lady spoke of his vision in forming an equal and respectful partnership with Maori and spoke of his chairmanship, his refusal to use his casting vote, and his determination to achieve unanimity with the Maori shareholders, his refusal to make polarizing decisions, during a 20-year relationship.

Bruce Mansell was an accountant (his firm is my accountant), and worked with his two sons, also accountants, who both spoke of him as a family figure rather than as the business leader.

Rather like the late Allan Hubbard, Mansell was known for his handshake deals, and his honouring of those deals, unlike Hubbard, who in his latter years appeared to exploit the trust he had engendered in his heydays.

All of this I record for it demonstrates the potential for well doing and mutual successes, in even the most selfish and riskiest of activities.

Bruce Mansell was a property landlord, a property developer, and a property financier, as well as an accountant.

He fended off takeover offers from the likes of the late Herman Rockefeller (ex Brierleys), believing that local ownership would be kinder, even when the money offered may have been tempting. Mansell continually invested more in Coastlands, growing it and modernizing it, almost every year.

I imagine every town and city might wish that its most powerful property people might be as parochial as Bruce Mansell was, and as proud to be in the community, coaching sport or sponsoring local charities. The recently departed GM from Coca-Cola simply wouldn’t understand!

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While the locally admired Bruce Mansell was attracting tributes last week, the internationally admired economist Gareth Morgan was attracting vitriol.

Unlike Bruce Mansell, Gareth Morgan wants to venture into the public arena, and wants to bring about change into areas of the globe that are awry.

Gareth, a man I know, admire and respect, has sought to bring about change in a wide variety of endeavours, including economic management, tax policies, climate management, protecting the Antarctic, fishing resource management and funds management behaviour.

He has used his intellect and discipline to research these subjects and has reached conclusions which, whether controversial or not, have added greatly to the very necessary public debates that must precede any radical changes.

He is a diamond, in my opinion, a rare character who is unafraid of sacred cows, who has cared not one fig for the opinions of those voodoo priests who belch out their usually borrowed or dishonestly-prepared opinion in public bars or internet forums, often with the most cowardly cover of anonymity.

Balanced, they are not. Many of the anonymous critics appear themselves to be failed financial advisers, one a failed finance company chief executive, another sounding like an insider trading cheat, rightly fired from an earlier job.

I have known Gareth Morgan for 30 years, having met him at management seminars in the 1980s where his views on future currency changes were strongly and interestingly communicated.

He has a gift for communicating, finding words that everyone can understand, and using colour to hold the attention of his audience. He is accountable for his opinions and is happy to take the role of David, when he spots an unwelcome Goliath.

He writes well, thinks laterally, is a generous philanthropist, and, quite frankly, has much more intellectual grunt and integrity than most.

I particularly admired his campaign to bring transparency to the funds management industry which in the 1970s, 80s and 90s was characterized by greedy, self-important, opaque policies which allowed mostly poor decisions to be paid for, un-transparently, by retail investors, while lazy executives grossly overpaid themselves.

I could not count the number of idiotic mistakes that were covered up by the retained profits of co-operatives, the decision of National Mutual to become a bank/moneylender, being one of the worst, but only one of many at places like AMP, NML, The National Provident Fund and Tower Corporation. The “bank” decision at NM cost NM policy-holders more than $100 million.

The losses were never itemized or identifiable in slush accounts, sometimes called “reserves”, or “contingency reserves”.

The selling culture in insurance products was often appalling, with many insurance and superannuation salesmen honoured for their gross sales, but rarely inspected for the integrity of their sales.

Demutualisation brought in some transparency but standards are still variable, today.

Meanwhile others, like Leadenhall Investments, indulged in practices that were toxic, insider information exploited, property purchases made despite blatant conflicts of interest.

Morgan has tackled these areas and then boldly attacked the financial advisers who have morphed from insurance salesmen into “financial advisers”, where their skill sets were and are rarely appropriate, their experience in investment markets often zero, their training rarely having embraced the culture of “client first”.

He published a book naming some of the despicable people who sought double brokerage from Bridgecorp yet were honoured by their selling group as the best of a crop that in Morgan’s (and my) view was chaff, rarely wheat, and rotten chaff at that.

You can imagine the vitriol he attracted from mostly anonymous “heroes”, unwilling to be accountable for their views expressed in the shadows of internet forums. It is fortunate that very few bother to read these internet forums. They are often a cesspit.

I recall a radio programme he and I once did in a studio for Chris Laidlaw’s excellent Sunday morning show on national radio.

Morgan (outrageously!) introduced himself and me as “anarchists” in the financial markets.

Recently Morgan has attracted flak from people poorly-informed about the endeavours being made to the Phoenix Soccer Team, which he part owns.

Soccer fans with no knowledge of the processes he has been asked to assist with have been labelling him as an ignorant intruder. They have been encouraged by the media which has failed to understand what he and his fellow funders of a struggling venture are trying to achieve. To me, their failures to understand have been wilfull. They just enjoy taking cheap shots at high achievers, especially wealthy high achievers.

Morgan, not his co-owners, has been willing to front up.

And then he published his thoughts on cats, stating they should wear a bell to alert birds of their presence, and that their population should be controlled by neutering, and by being kept indoors.

His science here was the effect on native birds of marauding cats.

I have no knowledge of this science, and no opinion on a subject that I have never considered, but I absolutely respect his right to raise a potential solution for a potential problem.

That is what we expect of bright, philanthropic, science-based, moral, decent leaders in our society.

You do not get any of that from cowards, or from those whose “leadership” is more to do with the compensation/rewards than it is to do with building a better world.

Having learned to ignore ignorant, “balanced” buffoons on internet forums whose “brave words” shelter behind anonymity, I have a small understanding of what strength Morgan must have.

I could not accept that he, or I, should be labelled as anarchists.

Pachyderms might be more to the point, with Morgan being a giant, deserving of far more credit than the infantile people who mock him, without first hearing his logic, or understanding it.

We need more Bruce Mansells and Gareth Morgans.

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While unanimity about the virtues of property players will always be unlikely, there is almost unanimity on a much more complex and important issue – the likely interest and investment returns over the next decade.

Life insurance companies are already preparing the ground to charge higher premiums, rather than cutting executive salaries and other expenses such as accommodation costs, to

offset low returns.

Pension fund managers, those who provide annuities, Kiwisaver managers, sharebrokers and unit trust salesmen have all been conditioning their clients to expect low returns from low-risk securities for many years.

Those wanting higher returns are being told that they must accept the risk of the equity market, and even more risk in international equities, with the continuing rise of the NZ Dollar appearing to be inexorable.

Many investors are seeking data on the dividend yields of reliable companies, though it must be said no future dividend is certain to equate with previous dividends.

I guess every broking firm, including ours, has its list of stocks it believes will return investors more than 6% after tax.

Investors wanting to achieve yields at this level can also consider the discounted perpetuals.

If you believe Rabobank, for example, will repay its 1-year reset bond (RBOHA) in 2017, then yields of at least 7% would be available to buyers (before tax).

The other instrument most likely to appear soon is the subordinated bank bond, likely to be 10 years with rates reset at five-year intervals, likely to begin at rates of around 5.75% (before tax).

These instruments will have loss attribution features.

I am not in the least discomfited by this.

If a major bank failed and was forced to renege on any of its liabilities, its next move would surely be closure, or transfer to new ownership, under Crown supervision.

Central banks wishing to enforce this new condition on banks are wisely directing attention to the absence of any implied “government guarantee” for bond-holders, a distinction made necessary by the events of 2008 and the state of some banks in Europe, North America and Britain.

The much stricter controls placed on banks has improved the situation, especially in New Zealand, where our banks have been surprisingly quick to meet new standards. I do not foresee banking failure in N.Z.

High yield shares, perpetuals and bank bonds seem to be the menu that our current investment environment provides.

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News that the receiver of St Laurence Ltd will collect the last of St Laurence’s loans soon is news that again sharpens the need for the Official Assignee and the Financial Markets Authority to complete their work.

To my knowledge, there is no fear of theft or fraud in St Laurence’s behaviour but there is little doubt that its directors will be asked to explain some of their brain dead errors,

once the losses are quantified.

To recall, St Laurence in April 2008 told investors and financial market people like me that it had adequate banking standby facilities from the CBA, that it had ample liquidity, had just made a profit of around $10 million and had no fear of its loan book, much of which was based in Australia, and all of which was based on property securities.

Within 56 days of this published work, St Laurence was seeking a moratorium, having no ability to repay maturing debentures without breaching its minimum liquidity covenant.

Within 86 days, St Laurence’s loan book was in tatters, ultimately destined to be collectible at a rate nearer 15 cents in the dollar than 20c, its other assets barely worth 10 cents in the dollar.

The failure of St Laurence’s directors to foresee this definitely requires explanation but the most unexplained errors came from the loan-making processes of the board and senior management.

St Laurence, its sister company Irongate, and its other fund St Laurence Property Development Fund, allowed lending in Australia that was every bit as naïve, indeed childish, as the lending we all now know was occurring in Bridgecorp, Strategic and South Canterbury Finance. How could such a diverse group of directors be so incompetent and how could they have failed to detect problems in April 2008?

Recall the slogan that St Laurence lent the money with the care they would apply to their mothers’ money. Poor old mums.

Whereas Bridgecorp, Lombard, Capital & Merchant Finance, Nathans and MFS (Octavius) were all demonstrably incompetent, and were visibly in chaos almost from their formative days, St Laurence had independent directors, had capital, had mainstream auditors and trustees, and was formally credit rated by genuine credit raters (Ron Keene’s AXIS/Rapid Ratings group).

Its bankers in April 2008 spoke well of the company.

The FMA and the Official Assignee will surely need satisfying that the undisclosed lending errors were simply the result of utter naivety, plastic processes, careless management and inadequate governance.

Were there evidence of culpable incompetence or negligence, or failure to disclose, then the insurers of the directors, auditors and trustees will yet again be in play.

That Strategic and St Laurence will return rather less than even dreadfully–run organizations like Christchurch’s Property & Finance is astonishing.

How did St Laurence ever satisfy its credit raters and bankers that its loan book was built on banking principles? The answer might best be left for the authorities to announce.

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Also answering to the authorities, this time in Australia, will be the private wealth advisers in Macquaries, whose standards were labelled “well below” acceptable levels, by the Australian Securities and Investment Commission (ASIC) this week.

ASIC’s public attack on Macquaries yesterday was astonishing, the more so as Macquaries is one of Australia’s biggest capital market players and promotes its client advice as “world class”, as EPIC investors were told last year.

One imagines Macquaries will need to prove that the detected shortcomings related to just a few maverick advisers and were not representative of its normal standards.

The Australian regulators are aggressive and have been for years.

Recall how they banned Bridgecorp 18 months before Bridgecorp called in the receivers in New Zealand.

It will always be a mystery that the double-paid financial advisers who sold Bridgecorp ignored the Australian judgement for nearly 17 of those 18 months, continuing to channel client money into the devastated, chaotic company till its last days. Perhaps nobody told them of ASIC’s decision.

ASIC may be too aggressive. The Macquarie response with teach us much.

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I will be in Christchurch on February 20, 21 (Russley Golf Club), Auckland on February 26, 27 (Waipuna), and in Nelson, Motueka and Takaka on March 8 and 9.

Edward is available in Wellington by arrangement on Mondays and Tuesdays.

Investors and clients are welcome to arrange appointments.

Chris Lee

Director

Chris Lee & Partners Ltd

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Taking Stock 24 January 2013

The 2012 news of David Ross’s “management” of other people’s money has clearly been a loud reminder to other one-man operations that investors must be treated with respect, and ignominy awaits those who cheat or disrespect proper processes and truthfulness.

Those who want to earn 1% or even higher fees from their clients have to prove that they add value, by helping clients get returns at least one per cent higher than they could do themselves, they have to use transparent processes, and they cannot adopt higher risk strategies just to earn that extra 1%.

The Ross debacle has led to a new burst of introspection from narcissistic provincial salesmen of managed funds. The internet forums have been cluttered with mostly self-focussed concern about the effect of Ross’ skullduggery on salesmen/advisers largely trained to sell insurance company products.

One provincial adviser has made the suggestion that all financial advisers should be forced to follow the lead of pension fund managers, allocating 40% of money to bonds, 50% to equities and 10% to property (or some such nonsense).

Such a one-size-fits-all approach would be moronic given that not all investors are 30, 40, 50, or 60 years old, not all have no investment other than a pension fund and not all enjoy the same objectives, health, marital status, family responsibilities etc.

Investing by decree from a manual sounds idiotic.

The suggestion was probably a spoof, aimed at getting attention. Times are tough, I guess.

To quantify how poor such a strategy would be I analysed the results of Kiwisaver managers, using their most recent published five-year results.

Kiwisaver has not been around long enough to use 10-year results.

The results should have reflected the fact that the Kiwisaver money received grows each year, so the bulk of the money has been invested in the last three years, during which most sharemarkets have had phenomenal rises, more than 25% in just the last year, in New Zealand.

Bond markets have also had remarkable rises, as rates have fallen, making long-term bonds with a high coupon worth much more than the original cost.

And property prices have recovered, though most of us would hope that these rises will stop. A very low interest rate meanwhile helps the property investors.

The only asset class to suffer lower returns has been cash, usually defined as short-term bank deposits.

In this extraordinary period, results ought to be fantastic.

If an investor had followed the annual picks of First NZ Capital (an unlikely investment strategy), they would have averaged double figure returns over the last five and ten year terms.

Here is what the Kiwisaver funds actually achieved in the last five years. (The averages shown for each sector are not weighted but the difference is irrelevant.) The rates are shown BEFORE TAX!

 

Kiwisaver Default rates (in low-risk assets) 5.07%

Cash/Fixed Income 4.63%

Multi-Sector Conservative 5.48%

Multi-Sector Moderate 5.00%

Multi-Sector Balanced 3.61%

Multi-Sector Growth/Aggressive 2.28%

Property 1.34%

Australian Equity 2.42%

International Equity minus 1.44%

The most disappointing and the best individual manager in each section, ignoring the irrelevant tiny funds were:-

Poorest          

Default            : AMP                       

Cash/Fixed Income : Westpac           

Multi-Sector Conservative : First Choice      

Multi-Sector Moderate : AMP                       

Multi-Sector Balanced : AXA                       

Multi-Sector Growth : Grosvenor      

Property : no meaningful funds to assess

Australasian Equity : Smartshares     

International Equity : Tower  

Best

Default : One Path (ANZ)

Cash/Fixed Income : AMP

Multi-Sector Conservative : Aon

Multi-Sector Moderate : Fidelity

Multi-Sector Balanced : SIL

Multi-Sector Growth : AMP

Property : no meaningful funds to assess

Australasian Equity : Milford

International Equity : none

Without wishing to labour the point, bank deposits have done better than any of these averages and even vaguely competent share selection has beaten these figures by an embarrassing margin, as any number of sharebrokers have demonstrated.

Those who advise and charge fees, would get their fees from the displayed results, which are shown nett of the managers’ fees but not nett of fees charged by an adviser.

Since Kiwisaver was introduced the best strategy has been to require the manager to invest conservatively.

Over a longer time this might or might not be the most lucrative strategy, but given the tax-payer donation ($1,000) the employer subsidy and the tax credit (50%), there has been very little reason to take much risk with the investment strategy.

Subsidies make Kiwisaver the best possible way of saving. The rate of return is relevant only if it is negative.

Management strategies to invest the money have been nice fee-earners but have done nothing to add high returns for higher risks, the sole exception being Brian Gaynor’s Milford Group, which achieved a stand-out return with its Australasian Equity Fund.

Provincial advisers advocating the strategies of pension fund managers are either spoofing, or goofing.

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My expectations for 2013 may well be at odds with those who advocate the use of pension fund strategies but one might expect this, given that savers are generally young, whereas our client base is largely 50 years or older.

In 2013 I expect to see the following themes.

1. Interest rates stay low, here and globally, as governments (USA, Europe, Britain, Japan) continue to print money to put the balancing of budgets into future election cycles. Governments and households effectively benefit at the expense of savers.

2. Sovereign debt levels rise.

As a result the risk of sovereign default will rise, but the returns (very low interest rates) will not offset that risk.

The gold price might be the barometer for that risk.

3. Corporates will have access to very low bank rates so the only corporate bond offers will be either at very low rates or will be subordinated or have no fixed maturity date.

4. Share prices at least for a while will rise, compressing the margin between dividend yields and bank rates. The rise comes from yield-chasers (from here and overseas), and from the Kiwisaver managers. The rise will confirm that sharemarkets do not represent the real state of the world economy.

5. Rights issues will occur regularly, and there will be many new offers, the best likely to be Mighty River Power, though I expect its pricing to be realistic. I expect some of the offers to be unattractive, and will be wary of the sales from private equity funds.

6. The biggest thrills of the year, I expect, will come as compensation claims will demonstrate that cheats do not prosper.

There will be no compensation for those rorted by poor public company sharemarket practices (ridiculous executive salaries, unfair share placements, shareholders paying for director/executive errors) but those who lost a total exceeding two billion dollars in the finance company collapse may see some progress.

Even in recent days there has been news that explained the need to move more power to liquidators, one example being the investigation on behalf of South Canterbury Finance preference shareholders who collectively lost $120 million in the SCF collapse, rightly not compensated by the tax-payer. The liquidator believes he has found voidable transactions.

Surely this will be the year when the SCF directors, shadow director, and chief executive are made accountable for the misleading and false statements made to the NZX,  Standard and Poor’s and the media in the early and middle months of 2010, and to explain the false claims made when Allan Hubbard shifted fully leveraged assets between companies.

These mis-statements led to investors buying, or not selling, the SCF securities because of the false hopes delivered to them.

Compensation should be achieved, perhaps partly paid by the insurers of these people, though it should be noted that “shadow”, or “deemed” directors would not be covered by SCF’s insurance. Surely the SCF deception cannot be allowed to be left in a corner.

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Investors seeking compensation know that whatever is achieved by vigilant, caring intelligent receivers and liquidators will go into a pool.

Different classes of investors, (secured, subordinated, shareholders) all may have been misled by directors, chief executives, auditors, trustees or valuers.

A recent trustee letter and another from an errant receiver claimed that only “secured” investors were eligible for a share of any compensation payments.

This, of course, is tripe.

In Australia last year shareholders misled by board announcements received compensation from the directors’ insurers (and the directors themselves) totalling tens of millions.

Receivers act for the secured investors; liquidators act for all investors.

Actually some receivers do not seem to act much at all but the truth is any category of investor who loses because of negligent or incorrect behaviour is entitled to seek compensation.

Indeed one of the parties who should be the target of a compensation claim is a receiver.

I refer here to McGrathNicol and its ex-partner Kerryn Downey, whose management of the SCF receivership was in my opinion incompetent, and cost tax-payers a sum of tens of millions of dollars, through poor decisions.

The Crown eventually removed McGrathNicol and put the remaining unsold SCF assets into what was effectively the Crown’s hands, but by then the receivership’s many bad decisions had done their damage.

The SCF preference shareholders claims would not benefit from a case against McGrathNicol as the losers here were the tax-payer but they certainly could link their losses to the false statements made before SCF fell into McGrathNicol’s hands.

SCF and Strategic’s bond and preference shareholders should not be put off by lazy or muddle-headed responses to their claims from trustees or receivers.

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The ripped-off investors in Blue Star Group bonds have now received the undertaker’s letter advising that the corpse has been interred.

One imagines the Blue Star Group investors are as likely to invest again with the Blue Star directors, management or shareholders (Champ) as the investors in Albany City Property bonds are likely to be impressed by the valuation skills of Colliers, which valued the leased Albany land at more than $100 million. (Its achieved value was … zero, or as near as damn it.) The valuer’s assumptions were risible, we all now know.

Blue Star’s seller in 2007 Tom Sturgess, an American based in Nelson, has repurchased the better bits of BSG. He has done well with his deals. He too is unlikely to be regarded as an investor’s friend.

With the help of the internet investors are better able today, than at any time before, to track the careers of those people and any organizations that prefer short-term income to long-term reputation, or appear to produce very poor outcomes for investors.

I could not fail to see the connection between poor behaviour and reputation when my holiday reading took in the 2012 book “Why I left Goldman Sachs”, published by one of the company’s several hundred (thousand?) vice-presidents.

The author of this book traced a 10-year career, surviving the boarding school-like initiation processes, then achieving distinction through a devotion to his clients and to the organization, during the leadership period of Hank Paulsen, later selected to head up Treasury and help the US to survive the 2008 crises.

As an interesting aside, Paulsen’s departure to government allowed him to exploit a US tax anomaly, which deletes any capital gains tax on share sales, when the sale is required by the government (to avoid conflicts of interest).

Paulsen sold $500 million worth of GS shares when he left to work for the US Treasury, with no tax liability. Nice little bonus. Saved himself  $130m, or thereabouts.

The author of “Why I left Goldman Sachs” traces an alleged change in GS culture to Paulsen’s departure and the arrival of Lloyd Blankfein whose trading background led to a focus on short-term profits, according to the author.

He quotes executive management and Blankfein in particular who argued that profiting from one’s clients was “okay” because clients were “big boys”.

He quotes a director telling him that if there were choices between profits and reputation, “choose profits, reputation can be fixed later”.

The book was surprisingly well written and surprisingly balanced in that it defended GS behaviour in years when others would be less generous.

It created a stir in the USA because the GS vice-president arranged to exit GS, unannounced, on a Sunday afternoon, so that the New York Times could publish his account of life in GS in the daily paper.

Its link with the likes of Blue Star Group in my mind was created by the allegations that the company failed to take proper account of all of its stake-holders.

In betting against its clients, as GS did during the Credit Default Swaps scandal, Goldman Sachs made the elementary error of failing to understand its own business.

In any financial services business, success follows on from client success.

In order of care, clients come first by a light year, from the others in the mix, staff, executives, shareholders, and society itself.

No clients, no business.

I made this point loudly twenty years ago when our banks began to pursue profits from selling the likes of travel, insurance, real estate and especially managed funds, and high-cost credit (credit cards).

When banks sacked staff who would not sell, the result was disastrous, one bank in New Zealand losing three such staff to suicide.

Bank clients did not – DO NOT – want to be sold anything. Bank staff did not join the banks to be sales people.

The clients want to be able to trust that the clients’ interests always come first. Bank staff by definition are administrators, not salesmen.

Occasional failures, such as when various ANZ salesmen over-sold the wretched ING Diversified Yield Fund and the Regular Income Fund, cost the banks millions, though dozens of equally guilty “advisers” in provincial towns were just as guilty but not put in the compensation process, for reasons unknown, for these funds were demonstrably mis-sold.

[In this instance the ING debacle cost the ANZ at least $200 million]

As we look ahead to 2013, one great improvement I see in NZ financial markets is the growing recognition, perhaps led by the powers exhibited by the Financial Markets Authority and by the decisions of the High Court, that clients’ rights come first.

Indeed that principle is now paramount in the Code of Conduct described by the Financial Advisers Act.

The villains and hypocrites who indulged in front-running (exploiting asymmetric information), insider trading, using shareholder money to buy personal assets, ridiculous fees, flogging off flawed goods etc now have no-one’s respect and will eventually disappear from our markets.

As we preview 2013 one clearly positive sign is that those who cheat will be dealt with if (when) they get caught. Bucket shops will be targeted.

We need such positive developments.

The world operates best when cheats do not prosper.

Lance Armstrong might not be the only example of this by the time we reach 2014.

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Kevin will be at the Russley Golf Club in Christchurch on January 31.

I will be in Christchurch on February 20 and 21 (Wednesday p.m, Thursday a.m.) and Auckland on February 26 and will be in Nelson on Friday March 8, pleased to make appointments with clients or investors.

Michael will arrange and advise his travel dates for February/March when he returns from his Lake Taupo “research”, a good story if ever I have heard one!

Chris Lee

Director

Chris Lee & Partners Ltd

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Taking Stock 17 January 2013

Virtually every year, in the Xmas, New Year period, you can count on certain headlines.

Any unfavorable corporate news will be released in the expectation that in the hustle and stress of pre-Xmas the headlines will not be noticed.

A second certainty is that the media will release lists of “hot” investment opportunities, selected by people ranging from serious analysts, bucket shop operators and the wild men of Borneo (as my grandfather would say).

There were two very serious corporate developments released in the festive period, the first bringing great attention to the hopes of investors for compensation from losses caused by corporate misdoings. (All receivers, pay attention please.)

The first, obviously, was the news that the designers and marketers of the cynical Credit Sails product had elected to pay out $60 million rather than face prosecution under the Fair Trading Act, which has severe penalties for those who mislead or deceive.

Those penalties may include jail, under certain circumstances.  Some concerns that the Credit Sails designers and organizers successfully defended were based on the wizardry of the design of the product, the decision to ignore legal advice that the underlying securities were unsuitable for retail investors, and the decision to insert the securities of some doomed Icelandic banks after investors had forwarded their cheques.

The fine print in the unusually complex offer documents must have satisfied the Commerce Commission that all these suspicious matters were Kosher, as the late Allan Hubbard might say.

What clearly was indefensible and led to the settlement was the marketing of Credit Sails as capital protected, sometimes verbalised as capital guaranteed by Forsyth Barr salesmen.

The Commerce Commission, investigating these marketing matters, required comprehensive disclosure of all internal emails and if necessary had the right to dismantle computers in pursuit of forensic evidence of undisclosed correspondence.

Clearly if the staff of the organizing broker (Forsyth Barr) were sufficiently confused that they themselves were telling investors that the investment was “capital guaranteed”, then the Commerce Commission had a strong case.

If any documentation had sought to emphasize strengths and “de-emphasize” obvious weaknesses, this would have further strengthened the negotiating power of the CC.

However one looked at this, the outcome of any prosecution was unlikely to help Forsyth Barr at a time when many believe its best hope of a meaningful role would be in merger with the Australian company Macquaries. This merger would be an attempt to make both of these small New Zealand operations into a relevant, modern market participant with new leadership, a new culture, and an ability to build on the capital strength of Macquaries and the South Island clients’ historical loyalty towards Forsyth Barr, a Dunedin company.

At a time when long-standing Forsyth Barr directors, like Eoin Edgar, Michael Sidey and Michael Devereux are all focused on retirement, such a strategy makes sense for FB.

Edgar’s sons Jonty, Adam and Hamish might once have been the heirs that brought in a modern culture but they all appear to have succeeded elsewhere, in somewhat more modern and dynamic organizations, and none might want the challenge.

Who would blame them for declining to take on such a task?

Macquaries, whose retail presence is barely noticeable in New Zealand, is far too vain as an organization to accept its kindergarten status in New Zealand.

In Australia Macquaries is the Ocker version of Goldman Sachs – a “millionaire’s factory”, as it has been often described by those who observe the executive bonuses, (rather than the shareholders dividends).

Why would such an organization have a presence in the “western islands off Tasmania” if its daily market share of NZX turnover, like Forsyth Barr’s, is a small one-figure percentage, not even 7% between the pair of them?

If there were to be a “merger”, surely Macquaries, as the party with the money to make it happen, would want to quantify the potential cost of the various unresolved issues facing Forsyth Barr, of which the Credit Sails investigation was one and the South Canterbury Finance debacle is another.

The SCF issue is likely to force FB to justify its contribution to SCF’s failure. Macquaries will want to know the outcome before it offers to “merge”.

Resolve such issues, clear the decks, clear out any dead wood, fire up the staff under new leadership, implement a relevant modern culture, and then have a crack at the big boys (First NZ Capital, Goldmans, Deutsche Bank, UBS and the trading banks).

I think we saw the first step of Edgar’s plans when his beleaguered chief executive Neil Paviour-Smith fronted the media in the days around Xmas, explaining that the lesson he had taken from the Credit Sails farce was the need to tell others of his good work in fighting for justice on behalf of investors.

I imagine someone else somewhere, perhaps in Latvia or the Dominican Republic, will believe that indeed that was the main lesson he should have absorbed.

Perhaps he will be the front-runner for a role with Macquaries in Queensland after a merger.

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The second “Xmas” story was told by the over-worked PricewaterhouseCoopers receiver John Fisk whose hat must house a colony of rabbits that would inspire Central Otago marksmen, given the magic expected of him with all his receivership hats.

Fisk disclosed that he is “negotiating” with the directors of Lombard and Strategic, those two finance companies whose outcomes have brought shame on those involved in the errors, at governance and management levels.

Fisk seeks an offer of money from the various directors and shadow directors to avoid the further legal costs implied by High Court proceedings during which full disclosure of those “errors” might well be front page news, even in women’s weekly magazines.

The offer had better be in tens of millions or Fisk should head for court.

Strategic’s directors and shadow directors are collectively estimated to own assets valued at more than $300 million, if one includes assets in various structures, such as trusts or personal companies.

Investors would lose around $350 million as a result of Strategic’s “errors”, if there were no compensation from those responsible for the losses.

Negotiations will be interesting. Coins will be of no relevance.  Fisk’s skills at representing investors effectively will be on full display, his skills in this tough role not yet proven. I will not be the only person watching.

Lombard’s directors are guessed as having assets worth nearer $10 million. Their investors have lost around $100 million.

Negotiations with them will be less fruitful but should still be aggressive.

Investors in both companies should not feel that those negotiations will be the last of the restoration effort.

Undoubtedly, the Lombard auditors will be a later target for compensation and in both cases the trustees, Perpetual Trust, will be asked to come to the table.

Lurking behind all such talks will be the insurers of all these parties, likely to be AIG, Vero, QBE or Lumleys.

Fisk’s first volley cleared the net in the silly season but one imagines those looking to return the ball will realize that there is not much seasonal goodwill in this business and that the responses will need to be extremely generous to avoid court cases and potential ignominy.

The fallback position for Fisk is the use of litigation funders, and the High Court. He will not want to be seen as appeasing the OBN, (Old Boys Network), or to be seen as a weak representative of investors.

Litigation funders are usually well-funded, have access to highly motivated legal teams, are fiercely determined, and in at least one case have personal views that finance company victims deserve very strong representation. They have the funds to play hard ball and they have motivation. Their interests are met by winning the best possible compensation deal. The OBN means nothing.

Fisk will know that the Financial Markets Authority is determined to make the statement to corporate New Zealand, that lazy, silly, negligent, selfish, deceitful or manipulative behaviour will never be accepted again. (The 1980s should have been the end of that.)

If the FMA or the Official Assignees Office had to take over the prosecutions, they would be fully tested, in terms of resources (financial and human) but the “errors” made by the likes of Strategic, Lombard and South Canterbury Finance have been far too great, in dollars lost, to be written off. The FMA might be a mean opponent, as might the OAO.

Fisk’s negotiations will need to be fierce, the more so as PWC itself will be under the corporate spotlight in April when it appeals Justice Fogarty’s rulings, which implied “errors” of a serious nature within many prominent organizations, including PWC. Fogarty’s judgement, available on our website, is an unexploded bomb.  PWC will know it is in the spotlight.

Those who during the silly season were asked to foretell events in 2013 might have found safe ground if they had forecasted that in 2013 there would be some compelling negotiations that would lead to very good news for investors in the worst of the finance company failures, one way or the other.

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The 2013 sharemarket forecasters quoted in the media embraced those who perform research so well that they regularly win industry accolades … and it embraced those who either guess, or who at best buy mass-produced “research” from research sellers who should never have won any meaningful awards.

Sadly most who give advice or forecast markets in New Zealand either guess, or operate on mass-produced research with little insight into evolving financial markets. Worse, one weak researcher services most financial planners.

Genuine research is expensive, fraught with difficulties (nonsensical accounting standards) and requires experience, intellect, mathematical skills and more than a single dollop of prescience when it gets to the point of making assumptions.

Many of the 2013 guest forecasters nominated Diligent as one of their “hot” picks.

Diligent shares are priced around $5.50, having been less than $2.00 a year ago.

Diligent sells software that enables directors to access their board papers on I-Pads and the like, thus making the highly sensitive information available anywhere there is network access, and making bags full of papers an anachronism.

It costs Diligent about 30 per cent of the annual subscription fee to acquire a new customer so the secret to Diligent’s success is to keep signing up more companies, using the same already-completed product.

If a tipster can correctly forecast how many new customers Diligent will acquire in the next year, he/she might then use maths to figure out the revenue, the earnings, and the free cash.

If somehow the tipster could be sure that Diligent would not face new competition with their propriety software, and would effectively have a monopoly on the good idea for many years, then the tipster might be able to deduce a future price for the Diligent shares.

In doing so he would have to guess the multiple of earnings that investors would apply, when valuing each Diligent share. Ten times earnings? Twenty? Thirty? A hundred?

If the tipster was really brave, he/she might guess what multiple a bigger organization might pay to buy Diligent and add the single product to the buyer’s range of products.

If the tipster was really smart, he might guess the name of the buyer and might analyse potential savings to the buyer, assessing synergies and cost savings.

From all the mathematics and guesses he might then forecast a share price potential, and then he might publish his tip. If the tipster had a moment of honesty, he would disclose to the readers of his “tip” that he owns, or does not own, the share before he releases his tip.

Experienced investors will have observed a number of “ifs” in the above paragraphs. (Five “ifs” and four “guesses”.)

Not long ago I discussed with a researcher a paper which forecast that another software selling group, Xero, had the potential to achieve millions of customers, gaining a double figure percentage of market share in Europe and the USA.

If Xero did this quickly, going from zero market share to a double figure percentage of penetration, then Xero’s shares, now north of $7.00 might be worth $60, one researcher wrote.

I was too polite to counter this with the thought that if Michael Campbell missed no putts under 20 feet then he would win every tournament he entered.

Research, analysis, mathematics, knowledge, intellect and experience combine to have a definite value.

Assumptions are guesses.

Combine the two, and the outcome can be … well, anyone’s guess!

Disclosure:  I own Diligent shares.

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Some Credit Sails investors have wondered how an estimated $20 million contribution from Forsyth Barr shareholders, $20m from insurers and $20m from Credit Agricole’s subsidiary Calyon, could repay 85% of the $91m contributed by the original CS investors.

Surely 85% of $91 million is $77.35 million, investors ask, not $60 million.

The answer is this.

The $91m issue was listed in May 2006.

In July 2006 some, including our firm, advised investors to sell Credit Sails on the secondary market.

Many did sell, including those of Forsyth Barr’s clients who were advised to quit by their FB advisers.

Some sold for more than 85 cents, some less.

The offer today is not to pay anything to those who bought the stock on the secondary market.

Perhaps $25m of the $91m was sold to secondary market investors. Those buyers will get no compensation.

The compensation is only for those who were influenced by the original marketing of Credit Sails, which, the argument goes, was potentially misleading and deceptive.

Everyone who bought Credit Sails on the original issue date will be entitled to receive 85c if they did not sell, or be topped up to 85 cents, if they sold for less on the secondary market.

Payment should be completed by the end of March 2013.

At that point all investors should write to Catherine Butterworth at the Commerce Commission and thank her and her team for strong-arming the erring parties into stumping up $60 million rather than face up to her in court.

The Commerce Commission and no-one else caused this compensation to occur.

Will the likes of Fisk learn anything from the CC’s victory?

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Another piece of “silly season” news was from PGC which has conditionally sold the virtually worthless Perpetual “wealth management” business along with its shareholding in an undistinguished Australian financial advisory group.

No price has been disclosed.

No mention was made of involving Logic Funds in Wanaka where PGC’s managing director George Kerr is said to have a financial interest, though it is most unlikely that Logic would be linked to Perpetual without careful disclosure.

Kerr had previously promised that if he could get any nett sum by selling Perpetual he would hand it over to PGC shareholders as a capital return.

By my guestimate, the sale proceeds would not likely do much to restore the sums lost in PGC since Kerr persuaded many PGC believers and some wealthy Australians to help him take over PGC.

I guess PGC shareholders would be pleased to get a couple of cents per share from this sale, if it occurs, but their greater pleasure would be a fair offer from Kerr for the shares he does not yet own.

A fair pay-out was once calculated by a British investment fund as being around 60c per PGC share.

Right now I suspect High Court appointed valuers would probably struggle to get anywhere near this figure so Kerr may yet gain complete ownership at a price that will alienate every shareholder who answered his plea for help, when he had his 41 cent rights issue, now effectively an 82 cent rights issue, given the consolidation (1 for 2) of the shares.

Kerr, I am told by a Wanaka spokesman, is fairly unlikely to revisit New Zealand.

Like Michael Fay and Eric Watson, he may head for a period in Europe, where he would be able to work privately to restore his legacy.

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The Serious Fraud Office is back in court next week with some South Canterbury Finance directors and executives. Of interest will be the testimony of Stuart Nattrass, likely to be the main witness for the SFO. Nattrass, of course, was himself a SCF director till late 2009, when he crossed swords with Allan Hubbard after some years of working with Hubbard.

The next court date is unlikely to reveal much. The main event will be later in this year.

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Kevin will be in Christchurch at Russley Golf Club’s boardroom on January 31, available to investors and clients. My February dates for Auckland and Christchurch will be set next week.

Chris Lee

Director

Chris Lee & Partners Ltd

Next week: What happens with compensation raised? Are the receivers misleading correspondents by claiming that compensation belongs solely to secured debenture investors?

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