Market News 29 August 2016

I thought I might have a crack at tax policy, in conjunction with employment.

Weak employment outcomes and weak income for the lowest paid plays a significant role in the political disruption that we are witnessing around the world.

There are plenty of reports describing how robotics will replace many employees in the years ahead.

In terms of pure economics this may make sense, if employees are retrained for other necessary roles in the economy, but I think we all know that practically this is unlikely to happen and certainly won’t happen simultaneously even if it has a chance of being right.

This implies that governments may need to begin addressing tax collection strategies in response to robotics, resulting in better tax options for businesses which employ real people.

Perhaps remove tax deductibility from machinery?

This would force use of machinery to the point that it was demonstrably was more efficient at delivering productivity improvements than a person and thus that person really does need to find alternative employment within that economy.

I am certain the companies using machines (robots) will still find ways to minimise their tax obligations.

INVESTMENT OPINION

 

Credit Agricole – Local investors have an ongoing interest in this French bank as a result of them issuing subordinated, perpetual, securities (CASHA) in NZ in 2007.

The ‘journey’ of ownership has been almost as varied as that of a Hobbit.

CASHA investors look forward to returning safely to the Shire on, or about, 19 December 2017 and this less than certain outcome is at least increasing in probability as time passes.

The latest gradual lift in the market price of CASHA, above 90 cents in the dollar, confirms this developing confidence with respect to the likelihood of repayment.

If the securities are repaid at the end of 2017 the return available to new investors is unusually high, being the combination of the coupon interest at 5.04% and the price movement between current pricing ($91.75) and repayment at $100.

Market pricing of CASHA securities showed a significant loss of faith in the French, French banks, and European finances between 2011 and 2012, which was the centre of the ‘European Crisis’, a crisis which many commentators say Europe has not yet escaped. Italian banking certainly hasn’t.

Since 2012 the price of CASHA securities has appropriately drifted higher as European economics improved, as the European Central Bank made it clear they would do ‘whatever it takes’ to support the banking framework and as Credit Agricole specifically made successful steps to improve the strength and profitability of the bank.

In March this year Credit Agricole bought back from the market and cancelled (effectively repaid) about four billion of subordinated bonds that it had issued between 2008 and 2010. Presumably declining equity effectiveness and a discounted price motivated the purchases but it is evidence of the bank recycling its capital.

With thanks to friends at First NZ Capital I read the reporting for CA repaying a $400 million Canadian tranche of securities that were similar to the CASHA securities issued in NZ (subordinated bonds grandfathered in as equity under Basel III rules with a 10 year call date). Usefully from my perspective the Canadian tranche paid a lower credit margin than the NZ tranche (+1.20% relative to our +1.90%) which lends further weight to the probable repayment argument.

This capital management behaviour by CA is consistent with a market expectation for repayment of CASHA securities late in 2017.

Another relevant Credit Agricole press release caught my attention last week relating to a rising level of equity on its balance sheet, ‘core Tier 1 equity’ in this case.

After Credit Agricole’s most recent results (2015 – 2016 year) it invited the bank’s shareholders to consider using the Dividend Reinvestment Scheme to buy more shares rather than receiving the dividend (Euro 0.60) payment in cash. To incentivise reinvestment in the bank’s shares CA offered a 10% discount to the price of purchasing new shares.

I was astonished about the reaction; 83% of CA shareholders elected to reinvest their dividend in new CA ordinary shares. Remarkable.

This volume of dividend reinvestment combined with retained earnings added 0.39% to CA’s Common Equity Tier 1 ratio, which is now at 14.20%, which compares well to the current minimum of 10.50% including a buffer sought by the regulators (2.50%).

CA reports that the recent European banking stress test scenario saw them holding CET1 above the 10.50% minimum (11.20%).

More good news, that very few banks are able to report, CA received a credit rating upgrade (one notch to A1) from Moody’s Investor Service.

It is nice to witness good news and just as nice to share it with those carrying investment risks related to that good news.

Negative Interest Rates – Negative interest rates are reaching the public sooner than I expected.

Negative interest rates are already being passed through to corporate customers of the banks and this is appropriate as they have the professional staff required to manage appropriate reactions to this new ‘cost’ for surplus cash, where once there was ‘revenue’.

Profit margins on business from corporate customers are far smaller than from retail customers and typically corporate customers are far quicker to change based on competitive pricing, so keeping interest rate pricing for corporate clients aligned with wholesale markets makes sense.

However, I hadn’t expected retail customers to incur negative interest rates so soon; I had thought that the introduction of more fee measures would have arrived first, using smoke and mirrors to cloud the recovery of negative interest rates (a cost) via a different cost to the client.

Maybe the banks of Europe saw the Motor Trade Finance trial on fees in NZ and have shied away from charging fees that are unaligned to the costs being incurred by the bank.

So, straight to negative interest rates for retail bank depositors then.

The tide begins with a very small German bank, Raiffeisenbank Gmund, on the ‘idyllic Tegernsee lake, home of wealthy actors and sports stars’ (and the birth place of Porsche – Ed), who will apply a custody charge of 0.40% percent to deposit accounts over 100,000 Euros. They introduced negative interest rates to corporate customers in 2014 and stayed aligned with ECB movements.

These larger retail deposit accounts represented the majority of the EUR 40 million that the bank did not require for lending and thus it was sitting with the central bank at a negative interest rate (-0.40%) which resulted in an ongoing loss for the bank, one which was avoidable.

A bank board member said, probably with a wry German (or Austrian) smile, ‘If you don’t create an incentive to change things then things don’t change’.

The 140 retail customers captured in this defined net promptly moved the EUR 40 million into other investments or bank deposits with other banks which are not yet charging negative interest rates on deposits.

Let’s describe Raiffeisenbank Gmund as domino #1.

Actually, I have just read that it was domino #2 because the first bank to apply negative interest rates on deposits was Deutsche Skatbank but they limited it to people with deposits in excess of EUR 3 million.

Raiffeisenbank Gmund has lowered the bar significantly.

You know how this game works.

This EUR 40 million is the start of the ‘domino run’, or ‘snowball’ if you prefer.

All banks lose money if they pay out interest when placing deposits with the central bank but do not charge the bank’s depositors. Banks don’t tolerate this from corporate clients and as Raiffeisenbank Gmund passes a EUR 40 million problem to another bank, or banks, those receiving banks will in turn become frustrated with the rising scale of their loss and introduce negative interest rates (or custody charges) on retail client deposits too.

The unwanted amount being passed along will become many billions and the avoidable losses for banks will become intolerable. Collective losses for European banks are already reported as being in excess of EUR 1.3 billion per annum.

The CEO of Germany’s largest bank, Deutsche Bank (DB), already sees this problem coming, and rising in size, so is speaking (lobbying) publicly for a move away from negative interest rate policies. His position is selfish in that it is made on behalf of his shareholders who have seen the share price fall 45% this year and no doubt fears further lost value when the snowball reaches them, unless they then move to negative interest rates for retail depositors too.

Perhaps DB’s frustration relates to it being the largest bank and therefore it must wait until all of the smaller banks have moved to negative rates on deposits before DB can move (competitive tension).

The banks with the best lenders (and least cash held at the central bank) will win, and that will be an acceptable outcome for the central bankers of the world who for years now have been trying to press more money out into the real economy (businesses) rather than storing it on deposit with the central banks.

Mind you, at present there is a condition on this strategy too because central banks are barely tolerating the prospect of any bank failures even if they are poor lenders, witness Banca Monte dei Paschi di Siena S.p.A in Italy.

Central bankers will feel inspired by Raiffeisenbank Gmund’s actions and will be eager to see that the dominoes are now placed closely together so that the newly negative interest rate settings do indeed force ‘lazy cash’ to find more productive longer term investments.

European and Japanese depositors being introduced to negative interest rates cannot simply add a little duration to their fixed interest investing, by purchasing bonds, to resolve the negative returns because their central banks have become such aggressive buyers of bonds the negative returns now extend out to 10 years in many countries.

In Japan, where David Colman from our office is currently on a research tour, the central bank’s money is also reducing returns in the share market, having mostly run out of available bonds!

We in NZ are not immune from these dominos because the surplus cash will continue its global hunt for higher return options (any return – Ed) and this can be seen in the value of the NZ dollar which rises more easily than it falls and in the rising proportions of bonds and shares owned by international investors.

NZ does not have many of the woes of Europe and Japan but we are unable to avoid the medicine that is meted out.

This ongoing downward pressure on returns, in all asset classes, is beginning to feel like the unavoidable shade of sunset.

Investment News

Fed Speak – The Federal Reserve banks of the US had their annual meeting at Jackson Hole, Wyoming, where they no doubt huddled in various rooms, restaurants and bars to discuss ‘what should this year’s strategy be’?

On Friday night Chair Janet Yellen spoke - ‘The case for raising US interest rates has strengthened in recent months because of improvements in the labour market and expectations for moderate economic growth’.

Mmmmm, I am thinking ‘show me, don’t tell me’.

If the Fed does increase the Fed Funds rate again in December 2016 by 0.25% they will have my applause and the markets will have nothing to fear; +0.25% rate hikes per annum (the last was in December 2015) is not going to result in excessive market volatility or rapid changes to capital pricing models.

Yellen was challenged with the view that slower growth means future US interest rates will likely also need to be lower on average, some analysts have suggested that the Fed will have less room to fight future recessions because there will be less room to cut rates.

‘Such a view is exaggerated’ Yellen said, ‘because the Fed will be able to use bond purchases and forward guidance to ease conditions. It may also want to explore other options, including broadening the range of assets it can purchase, raising the inflation target, or targeting nominal GDP’.

I hope you all noticed how quickly the Fed is willing to return to 0% interest rates and to buying an ever-wider range of assets from the market next time it feels like providing liquidity (and asset price increases).

As I recorded above, the Japanese have made it to ownership of shares, will the US Federal Reserve be forced to that point one day too?

There is certainly no hint of high interest rates in any of today’s forward-looking analysis.

Dividends Up – The reporting season is throwing up a plentiful list of businesses confirming financial performance at or better than expectations and in several cases businesses are offering increased dividends, which is welcomed by investors as they watch their interest rate returns decline.

Vector, for example, has managed to increase their dividend by 0.25 cents per share whilst exiting underperforming businesses (gas) and trying to increase the scale of unregulated business lines. Increased dividends during times of strategic change is both impressive and it reflects the very high cash flow enjoyed by this business, and the reliability of its revenues.

There are plenty of others reporting higher dividends too, shares which many of you own; Meridian and Mercury (AKA Mighty River Power) are two more examples and we spoke about the increased dividends from the listed property sector last week.

The government should also be pleased as it continues to receive increasing dividends on its 51% shareholdings in the energy sector and also a strong lift in the dividends from ‘our’ airline, Air New Zealand, which increased its dividend to 20 cents per share and has hopes of holding it at that level in the foreseeable future (they also paid a 25 cent special dividend).

Taxpayers with long memories may recall that the government (Labour at the time) purchased 88% of Air New Zealand for the equivalent of $1.15 per share (with the average ownership price reduced by the gain made when shares were sold to the public in 2013).

It’s nice also to see some of the agriculture sector reporting increased dividends too, namely; Fonterra, Delegats, Seeka, Turners & Growers, Scales and PGG Wrightson (the ones I spotted).

Those of you who regularly read Brian Gaynor’s articles in the NZ Herald, which I would encourage, will have seen a useful summary on this subject last week. He points out that the very good performances by the majority helps to justify the currently high NZ share prices but they’ll all need to do better again (my words) for the market to move higher from here.

The dividend increases are small increments but they are reinforcing the higher pricing of some companies’ shares and increased returns are always welcome.

Warning – If you have been approached, usually via a cold call around dinner time, by a business such as ‘Options XO’ urging you to enjoy the profits of options trading don’t be fooled.

Firstly, any website that displays desert islands, bikinis and yachts discloses a business that is not serious about financial advice or trading;

Secondly, retail investors should not be trading derivatives.

Further, serious financial service providers do not allow you to settle up with credit cards. Profit margins aren’t wide enough to pay credit card fees!

If by chance you have engaged in opening an account and made a payment I suggest you ask for a refund.

Ever The Optimist – Japan proposes to save the planet, by producing the 2020 Olympic medals from recycled metals extracted from redundant technology.

ETO II – A large UK investment manager has removed bonuses from its remuneration offering after concluding that ‘bonuses are largely ineffective in influencing the right behaviors’.

The reaction from the best employees may well be to try and demand higher fixed salaries but good on Woodford Investment Management for trying to correct a failed model.

ETO III – The milk price may finally be entering an upward trend.

Fonterra has increased the payout estimate to $4.75 and current market pricing supports a result above $5.00. Combine this with Fonterra’s estimated dividend per share between 50-60 cents and there’s every chance the sector will be widely profitable again.

Further, the rising volumes for milk futures on the NZX make it easier for farmers to manage their own milk sales pricing further into the future.

If you, or your friends, happen to be large-scale dairy farmers and you have not opened an account with a futures broker then you are missing an important strand that should feature in your business risk strategy.

If you do have a derivative broking account ask your contact to explain options to you also.

Investment Opportunities

Kiwi Property Group (KPG020) – offer of a seven-year senior bond (secured by the properties) with a minimum interest of 4.00% is happening now, and fast.

We seek an allocation on behalf of our clients this Wednesday (all firm investor interest must be with us by tomorrow night please).

Once an allocation is confirmed to us we will then issue contract notes to confirm client allocations to those who confirmed participation. Payment will be due in the following days.

If you wish to invest in the KPG020 bonds being offered please contact us urgently.

Spark Bond – Spark has announced an intention to offer up to $125 million a new senior bond with a 10-year term (7 September 2026).

This will be a fast moving transaction (arranged this Wednesday), booked by contract note with investors paying the brokerage.

We have estimated the interest rate as likely to be about 3.95% per annum (quarterly payments).

If you wish to invest in this bond offer please contact us no later than tomorrow at 5pm.

Z Energy – has now announced that it proposes to offer a new bond (presumably senior again) to replace the bond maturing on 15 October 2016 (ZEL010).

There are no more details at this stage but you can be sure it will be a longer-term bond (5 years or longer) and that the yield offered should reach, or slightly exceed 4.00%.

We have started an email list for this offer which investors are welcome to join.

Travel

Edward is in our Wellington office (Level 15, ANZ Tower, 171 Featherston St) on Tuesdays, available to meet new and existing clients who prefer to meet in Wellington - by appointment please.

Investors wishing to make an appointment are welcome to contact us.

Michael Warrington


Market News 22 August 2016

There is a surprisingly large amount of angst around the debate over extending the Wellington Airport runway.

If the business expansion can occur without subsidies, and thus stand on its own commercial feet, surely the Wellington region would be proud of such economic expansion?

INVESTMENT OPINION

 

Interest rate setting – I side with the banks when it comes to setting their interest rates for deposits and loans.

Banks operate in a very competitive environment. They do not need politicians telling them how to set relative pricing.

Debt reduction is always a wise strategy. Senior bank executives and now cabinet ministers are reminding the public of this point. If the relative pricing to borrow money worsens there is an increased incentive for borrowers to repay debts; simple really.

If 0.15% of an Official Cash Rate cut is not passed on to borrowers, then those borrowers can achieve the same cash savings by repaying 3% of their loan capital a little faster (based on current nominal interest rates).

New Zealand’s excessive use of debt (private, not government) is what enables banks to increase the pricing of debt and they are not going to receive any criticism from the Reserve Bank for doing it.

If borrowers position themselves without competitive choices for borrowing elsewhere, such as an investor with a Loan to Value Ratio higher than 60%, then they have very few options for negotiation (other than weak political lobbying – Ed).

This is why I highlighted this risk in a recent Market News item after 60% LVR restrictions were announced. Investors with LVR’s above 60% have been boxed in and would be very wise to make aggressive debt reduction efforts, immediately, before the banks introduce differential pricing for investors relative to home owners.

Differential pricing won’t just be a commercial threat from banks taking advantage of borrowers who cannot move (although this is a risk those investors took), shortly the Reserve Bank will (my opinion) introduce different risk weightings (more bank capital required) for investor loans and this will also drive higher mortgage rates for investors relative to home owners.

The message is clear; if you are a property investor you must start thinking more like a business person than a property speculator. Your costs and risks are rising and you would be wise to react to these new influences now, not later.

From a homeowner’s perspective mortgage rates are cheap in both nominal terms (low interest rate) and real terms (house values are rising faster than interest rate costs). The fact that banks are not passing on 0.10%-0.15% of OCR is of minimal influence to the financial outcome.

Communism by stealth? – The Japanese government, by way of the Bank of Japan, is fast becoming the largest owner of many private Japanese companies (listed on the stock market).

The BOJ is reported as being a top five shareholder in 81 companies and based on current trends will become the number one shareholder in 55 of those by year’s end.

Beyond having fun with my headline this behaviour makes no sense, other than to confirm the transfer of wealth from wider taxpayers to the micro group of asset owners.

The presence of the BOJ on a company’s share register does not suddenly make the business more profitable so the upward pressure on share prices is artificial and at least a 1:1 loss of wealth for taxpayers.

On a misty day when all things seem unclear maybe the BOJ Governor Haruhiko Kuroda would explain to me that he is making money whilst he borrows via Japanese Government Bonds (JGB’s) at negative interest rates (ie gets paid to borrow) and receives dividends from ‘his’ companies.

On a single day in the cash book he would be correct.

However, in my opinion Kuroda has oversized blinkers on if he believes that negative interest rates (for the long term) plus having the government as the largest investor in private enterprise represents a strategic path to economic success.

The behavioural incentives are wrong so the experiment is ultimately doomed to failure.

What will cause its failure, and when, is not clear and thus making investment decisions today remains very challenging (among many other financially challenging situations around the globe).

No, I don’t think the Japanese have suddenly decided to give communism a go but their attempts to provide money to all via ownership of everything are seriously misguided.

After thought – Presumably the BOJ is buying the likes of Toyota to support local business. How would the BOJ react if Toyota moved its main stock market listing to the US and its main volume of employees was outside Japan?

Pay – I nearly put these thoughts further down the page under Ever The Optimist, but as usual I find it hard to keep things short when I let those thoughts run away unrestrained.

I compliment Simon Moutter and Spark on their decisions to lift the minimum wage that they pay to $19.20 per hour (trying to introduce a new brand ‘Spark Pay’). I know they need to pay competitive wages to attract the best staff but to actually increase the payment is a difficult decision when directors are focused on shareholders not employees. I think I heard that they also plan to offer interest free loans to staff wishing to buy Spark shares, which is an intelligent way to encourage staff to align their efforts with their wallets whilst having some skin in the game (return for risk).

Next though I found myself agreeing with the journalist (my apology for not recording the name to repeat here) who pointed out that Simon Moutter is only half way to the point of good leadership with respect to staffing; he also needs to cut the excessive incomes at the top of the business.

I don’t wish to start defining what those top level incomes should be, but everyone, including Simon Moutter, knows that one doesn’t need to be paid millions per annum to be comfortable financially, or successful with respect to business goals.

I would like NZ’s most talented and hardworking people to get ahead financially, but if one achieves excessive wealth from hours worked rather than capital investment risks the situation is out of balance.

In my experience many people who have accumulated large wealth via hours worked, rather than business investment, tend to be very conservative with the way those savings (capital) are invested, which means the surplus (more money than required) of that money becomes lazy and does not assist the economy as much as it might.

Simon Moutter touched on this point recently too with his offer to push for more investment into fledgling businesses (higher risk, but part of an evolving economy) that require capital to pursue targets for success. This is another good display of leadership by him.

So, again I agree with the journalist, for Simon Moutter to secure three stars for his current push, and the undoubted support of his staff, he’d do well to reduce the scale of incomes at the top as he tries to push up incomes at the bottom.

Heartland Bank (HBL) – I like this story.

For several reasons too;

HBL has built a successful (well governed, well managed and increasingly profitable) finance sector business (now a bank) out of the ‘difficult’ space that was the Non-Bank Deposit Taking landscape in New Zealand in 2007-2008;

Senior executives at HBL in 2008/2009, had much easier employment choices available to them in the face of the Global Financial Crisis and the mountain of work they confronted to build a new bank, but they set a strategy in place and have stuck to it for eight years now. This alone deserves the most applause;

Patient investors, including me, chose to believe in the real people leading the bank and their commitment to the strategy and those investors have progressively been rewarded with rising profits, rising asset value and rising dividend payments; and

HBL is the only ‘NZ bank’ listed on the NZX, thus offering full imputation credits, when available, from NZ business activity and thus it is not complicated by income splits impacting gross returns as we experience from the major banks.

A braver government would change this by selling 49% of Kiwibank and offer us a second local choice for investing in local banking.

When investing one seeks investments that are reliable, scarce or expanding (positively), or a combination of these qualities.

In our view you find Heartland bank squarely in the ‘expanding’ category and their discipline in sticking to strategy plus presence in the banking sector means that reliability is an apt description also. (Meatloaf may well be found on the share register – Ed)

It took a while but HBL has progressively convinced most investment analysts to become believers in this new bank and its ongoing potential.

We are pleased for the bank’s board and senior executives, they should be proud of their achievements.

Kevin Gloag has analysed the recently released HBL result in detail and written a very good article on the bank that can be found on the Private Client page of our website by those who seek financial advice services from us.

Investment News

Bank Capital – The high volume of capital required by the Indian banking sector is beginning to result in some stress, and has disclosed a failure by bank directors and senior executives to get on with the job of raising new capital (ordinary equity).

Last week an Indian bank (Dhanlaxmi Bank Ltd) deferred the payment of a coupon (interest) on some of its subordinated Tier 2 bonds.

The supporting commentary explained that the bank expects to make the ‘delayed’ payment once the bank’s equity moves comfortably above the minimum capital adequacy requirements.

That’s all very nice to say but the failure to stay ahead of the game (managing equity on the balance sheet) is a concern, as is the comment from credit rating agency Fitch that the Indian banking sector needs to raise US$90 billion of additional capital by 2019 to cope with mounting bad debts and rising capital adequacy settings.

Dhanlaxmi Bank is a privately owned bank. The Indian government has stated that it will be adding capital to the government owned banks. (show me, don’t tell me – Ed)

Australasian banking is very different to Indian banking, but it is a reminder of why markets demand higher credit margins from subordinated bank securities.

Where should subordinated bank bonds be priced (how wide should the credit margins be)?

The answer to this question probably lies at the pricing point when bank directors would rather re-open dividend reinvestment plans for shareholders or offer rights issues to raise new capital than issue Tier 1 subordinated bonds!

Perhaps financial markets should go looking for that point by reducing its demand for subordinated bonds? (resulting in higher credit margins, as experienced by the Royal Bank of Scotland recently with a Tier II issue with coupon interest above 7%).

Corporate Capital – Meanwhile in NZ, companies with robust levels of capital, high cash flow and low debt servicing costs continue to address ways to return excess capital to shareholders.

Port of Tauranga shareholders should read their recent announcement closely because the company plans to split the shares 1:5 and pay special dividends over coming years to return capital in a tax efficient manner. (this is cheaper than an annuity if you want a progressive return of your capital – Ed).

Interest Rates – The downward spiral continues.

Looking specifically at the UK; the market yield (return) offered on a 10 year UK Gilt (government bond) was 1.20% pre BREXIT. Today it is 0.50% and given that the Bank of England is finding it hard to find enough bonds to buy (money printing) this yield is likely to fall to 0.00% like many other nations interest rates (UK yields are negative for terms up to four years at this point).

Initially the public will see these ongoing interest rate declines as positive performance numbers from fund managers but the following quote from the head of the world’s largest sovereign fund makes the future clearer:

The fixed-income investments delivered “gains due to falling interest rates,” Grande said. “In the long term, however, lower interest rates have negative implications for future returns on the fixed-income portfolio.”

The ‘gains’ referred to above are seen in the performance reported by fund managers but these interim gains do not change the ultimate repayment sum, which remains the sum loaned in the first place.

It is common to read that ‘past returns are not a reliable indicator of future returns’. That is true, but future returns are staring us in the face in the fixed interest world, they are there to be seen on the yield curves of the world.

Extra-ordinary gains will only be made if interest rates fall further and fund managers know precisely when to sell everything and await a rapid rise in interest rates (brave plan – Ed).

It is repetitive, but nonetheless accurate, to say that low interest rates are a long term expectation for us, along with the majority of financial market analysts.

Property – Kiwi Property Group (KPG) has made a very interesting announcement in confirming that they are to build an office tower in Mt Wellington on their land at Sylvia Park.

The Sylvia Park flagship is a retail shopping complex with supporting entertainment and food options but this tower block development confirms that Mt Wellington (and its surrounding areas from Stonefields and Panmure down to Otahuhu) is likely to become a satellite city within Auckland City.

I guess this is typical of growing pains for cities; they reconsider land use and make changes to suit the rising population including taller properties in areas with less cost than the inner city. It seems logical to me that many of the older, worn down, industrial properties will begin to sell to property developers for different tenancy types as Mt Wellington evolves.

The KPG announcement also confirmed why investors should expect returns on commercial property to continue to exceed interest rates. KPG has secured IAG as an anchor tenant with a 12 year lease (everyone is capturing longer tenancy agreements now it seems) and they describe the net income return as 6.70% per annum.

The emergence of longer term leases is reinforcing equity value for shareholders (or unitholders) invested in commercial and industrial property.

Business growth South of the city centre does no harm for Goodman Property Trust either with its development focus at Highbrook just down the motorway from Mt Wellington.

Further on the commercial property sector, Precinct profit announcement reveals that they too are benefiting from increased demand in the sector.

It is hard not to be pleased when reflecting on these excerpts from them:

Increased profit (13%);

Increased dividend (0.2 cents per share);

 ‘Auckland city centre office market remains extremely strong with a continuation of historically low vacancy levels’ (60% of unfinished building already leased); and

‘Conclusion of the government’s Wellington Accommodation Project will remove uncertainty in the market providing stability’ (recall the 14 year lease agreement announced recently).

All good, as they say.

Ever The Optimist– Sequential rises for the pricing of milk is promising and hopefully builds a little optimism for farmers as they head out at 4:32am each morning.

Maybe the Chinese stock-pile built up for price negotiation purposes is running out?

Some analysis provided by the BNZ indicates that current market conditions imply a possible milk payout of around $5.00 which is estimated to be just above breakeven for most dairy farmers.

That being the case farmers with high debt levels would be very wise to discuss with bankers and brokers use of the milk futures market on the NZX to protect as much future income as possible.

ETO II – Unemployment down to 5.10% and employment up 4.5% year on year (69.7% participation) can only be seen as good news, especially given the very high migration numbers that NZ is coping with at present. (clearly there are no robots in NZ – Ed)

Investment Opportunities

Westpac Bank – the offer of Tier II subordinated notes closes on 26 August.

All applications should now be in.

Thank you to all who participated in this issue with us.

Kiwi Property Group – Has now announced its return to the market with the previously proposed senior bond offer.

We have been invited to attend road shows this week.

We will advise more detail to our new issues email group, and via newsletters, once we learn the details. We expect to learn about a long-term bond (beyond 5 years) and hopefully a return of 4.00% or better (below 4% will be challenging given the alternatives).

Stay tuned.

If you have already joined our mail list for this proposed offer we will be in contact shortly to re-affirm that interest.

Z Energy – has now announced that it proposes to offer a new bond (presumably senior again) to replace the bond maturing on 15 October 2016 (ZEL010).

There are no more details at this stage but you can be sure it will be a longer-term bond (5 years or longer) and that the yield offered should reach, or slightly exceed 4.00%.

We have started an email list for this offer which investors are welcome to join.

Travel

Kevin will be in Dunedin on 26 August.

Edward is in our Wellington office (Level 15, ANZ Tower, 171 Featherston St) on Tuesdays, available to meet new and existing clients who prefer to meet in Wellington.

Investors wishing to make an appointment are welcome to contact us.

Michael Warrington


Market News 15 August 2016

This new labour policy, or was it a ‘thought bubble’ may have legs with more people (parents) than National realise.

If Labour offers to repay my son’s student loan by ushering him out of our house to the regions then I am ready for a snap election.

INVESTMENT OPINION

 

Who can I blame? – I think the directors and senior executives should take a serious look at themselves, but predictably UK organisations reporting poor financial results are pegging much of their recent failure on BREXIT.

Quite how the Royal Bank of Scotland blames its 2 billion pound six month loss on democracy escapes me almost as much as common sense escapes their directors in blaming the British public (their customers) for the bank’s financial problems.

Clearly RBS directors and senior executives live in or near the City of London and thus surrounded themselves in REMAIN friends and managed the bank according to that localised poll, held at expensive restaurants and in polo clubs.

Well, in my view this poor governance and management practice cost the bank dearly.

Resignations should follow (but they won’t – Ed). What will follow is more weak performers blaming BREXIT for their financial performance.

The much weaker GBP currency should help UK exporters and the large cuts to UK bank deposit rates after the recent cut to the cash rate by the Bank of England (BoE cut 0.25% but deposit rates are being cut 1.00%) may well help prop up the UK share market, but my initial impression is that in many cases governance and management won’t be helping real performance.

All for one - The long anticipated generosity from the European Union knows no bounds, yet they too may wish to blame BREXIT.

The European Union has confirmed that they will waive fines for Spain and Portugal relating to these countries excessive budget deficits (defined in the Maastricht Treaty that formalised the union).

Nice things were said about exceptional circumstances.

The wet bus ticket tore before impact as the EU agreed to new dates for compliance with the 3% of GDP deficit maximums (Spain is at 5.15% and Portugal is at 4.40% - subject to calculation methods and reporting no doubt).

I wonder if the exceptions granted came with conditions about public referenda?

Automation – Stories continue to trickle across my screen about increased use of robotics and various other forms of automation and this is undoubtedly a threat to employment prospects for many.

The solution is not to fight the automation development but I think it would be very wise for employers to not place sole responsibility for this problem in the hands of each employee because to do so surely results in avoidable public discontent.

In their role as employees the public must remain alert to changes in the employment landscape. Where are the employment opportunities expanding, remaining stable and declining? However, company directors and business management, and to some extent government, has a better view of these trends and thus can act early in guiding the public toward areas of employment demand.

The recent announcement by the Ports of Auckland (POA) that it will progressively trim 10% of its workforce (50 of 500) from the stevedoring team through the use of automated straddle carriers got me thinking; where could those 50 people be used next?

POA explained that it hoped to manage the cut of 50 employees through retirement, general turnover and re-training. It read as being a bit hopeful to me and even if manageable smoothly it remains true that demand for stevedoring people is declining and thus younger members of the workforce must look elsewhere for their work opportunities.

It is a little simplistic to say, but as I understand it the heavy trucking industry is desperately short of drivers (owner operators is common). NZ ports’ willingness to set up land based ports as hubs between producers and coastal ports implies that trucking will remain an integral part of our economy.

So, I had a thought; couldn’t these people be quickly re-deployed into the trucking industry?

POA in conjunction with its union and the trucking industry could put together proposals to train some stevedoring staff as drivers, provide conditional carriage contracts and present an attractive financing package to hurdle the prohibitive cost of a big rig.

POA would achieve its cost savings and new business model, the union would achieve its ‘care for the employee’ goal and the trucking industry would add supply to its driver fleet.

I happen to think there is more responsibility on POA to assign some of the financial gains it hopes to make (profit increase multiplied by 15, being a common mid-point for Price Earnings ratios used to value businesses) to accepting some new risk in helping staff to re-train even if the new economics do not directly benefit POA.

In dollar terms this might mean the following:

Cutting 50 employees might save POA $2,500,000 per annum (net of new costs). The implied value to POA owners might be about $37,500,000 (15 x $2.5m). A big rig might cost $500,000 but the finance ‘subsidy’ provided by POA might only be $25,000 per annum for say five years as an offer ($125,000 per driver or $6.25 million if 50 people accepted the re-assignment offer).

A freight firm, such as Mainfreight might step in with its desire to access more drivers and offer initial commitments to pay the new owner/driver for freight movement, again, perhaps a conditional agreement for a five year term. This would display to the owner/driver the potential to succeed in this new business, and then position them to renegotiate extended freight agreements beyond the fifth year.

The employee has accepted new employment risks (truck costs, business flows etc) but they have been given a leg up to a new opportunity (financing capital, business flows) and under this scenario will develop an even better understanding of how business works and why their previous employer made the decisions they did.

I am sure I am missing something in my ‘one thought after another’ approach here but automation, when combined with proactive re-direction of the labour force, is not something to fight against; we just need to find a way to embrace it. (So, buy shares in both POA and Mainfreight? – Ed).

I wish it was that simple. We would need Auckland Council to concede that POA could be privately owned (or mixed ownership) to achieve that outcome. (It would provide more money for Len’s train set – Ed).

Christchurch City – On the subject of asset sales by councils, my POA thoughts above got me wondering about what Christchurch City was up to with its assets.

As it happens there was a recent story disclosing that attempts to sell ‘City Care’ had failed.

The new Chief Executive Officer said there was a lot of ‘water to flow under the bridge yet’.

He didn’t explain whether or not that water would be sold, or the bridge that it flows under.

Apparently Christchurch City Holdings Ltd are required to deliver $200 million in each of the next two years to the council but whether this is done by simply borrowing more money at the company level (pass capital or dividend to the council) or through the sale of shares still looks undecided.

If the politicians are desperate to retain control (51% shareholding), which is a model I am happy to see continue for such important assets, and you have a similarly desperate need for capital elsewhere surely the answer is to sell 49% of the shares in the asset (capital injected by private interests).

Aren’t today’s elevated asset prices the ideal time to sell unaffordable assets?

Investment News

RBNZ OCR – In a lesson for casual observers about how little control we have over the pricing of our own currency, the Reserve Bank cut the Official Cash Rate last Thursday by 0.25% to 2.00% and the NZ Dollar went up 1 cent (from about 0.7200 to 0.7300 versus the US dollar). It has subsequently begun to drift lower (whew – Ed).

The strength for the currency was a result of the RBNZ statement being considered neutral as opposed to aggressive which the market felt was necessary.

The RBNZ does forecast that another cut to the OCR is necessary but I expect they also want to allow more time to roll out macro-prudential changes and to gather evidence about their effectiveness.

The ANZ kindly invited me to an MPS after-match function and one of the bank’s policy makers spoke very well to us about the detail behind their thinking. They make it sound so simple, and often they ponder why we all make it so complicated in our analysis of them.

The RBNZ wants inflation centred around 2% (until they are told otherwise by government) and the want financial stability.

Like all central banks, ours will use monetary policy to guide inflation until they run out of monetary track and if that happens they’ll be very keen to see government spending increases to help the inflationary cause. On this latter point, and applying my view that the RBNZ will run out of leverage from their interest rate track, I am very keen for the government to use surpluses to reduce our government debt to their target of 20% of GDP or lower.

From that point on the government will be able to listen more kindly to calls for increased spending. This seems inevitable to me given the zero interest rates and weakened economics of many of the world’s largest trading partners.

Holding a majority of NZD assets continues to be a winning strategy and it is hard to see how this scenario will be broken and with such cheap money (very low short term interest rates) it is also hard to contemplate selling long-term assets!

The good news for fixed interest investors is that NZ banks seem to be following the trend in Australia of increasing their deposit interest rates.

XTB – AKA a doorway to senior bonds listed on the ASX for retail investors (enough of the acronyms – Ed).

One of XTB’s senior executives (A kiwi) paid us a visit last week to update us on their business progress and to then generously enter the boxing ring to raise money for the Blue Dragon Children’s Foundation while in town.

For those wanting an update on what XTB bonds are you might search past Market News items on our website and check out the company website www.xtbs.com.au plus making contact with us with any questions.

After launching in 2015 XTB has now grown to beyond $80m in size and is increasing by $10-15m per month. They now have 32 different fixed rate bonds available and six floating rate, with more of each coming.

XTB seem well on their way to becoming a large service provider to retail investors seeking access to senior bonds on the ASX.

The growing scale has also enabled XTB to start introducing what I shall light-heartedly call a ’20 cent mixture’; being the ability to buy a single XTB security item (investment) which in turn owns a subset of other XTB securities.

The facility is very useful for retail investors who until now found it very difficult to access senior bonds in Australia.

The fee is a fair 0.40% but I told them that in this very low return environment the fee needs to be reduced as XTB gains increased scale, and I think it will be in due course.

XTB does not withhold any tax, leaving that to each individual investor to resolve, and is getting back to me about whether or not they can have the registry offer a service to convert AUD interest payments into NZD, payable into a nominated NZ domiciled bank account (for those who do not have an Australian bank account).

Fees – This is always a topic that rises to the top for discussion and it will do so even more whilst we find ourselves in this very low returns environment.

The item that caught my attention for the longest moment last week was the announcement of the successful sale of the NZME building that was sold to a syndicate of investors.

Augusta reported capturing $2.9 million of fee income from the transaction, which calculates out as 4.15% of the money invested by those buying the building (converting $1 into 95.85 cents on day one).

It will take investors roughly one year’s after tax rental from the property to recover what they have paid out in fees on this transaction, even though Augusta generated that same fee over a much shorter period of time from a rapidly diminishing risk profile (ie the sale of the building).

The deal done was all as offered, but the fees are as displayed.

Fees II – Speaking of fees, this following story should have Augusta feeling positively charitable.

Investment banks are lining up to earn an estimated $250 million in fees for assisting Italian bank Monte dei Paschi di Siena with a $5 billion capital raising exercise.

That’s 5% commission!  Nice gig if you can get it.

The commission could be much greater than 5%. The story (on Reuters) summarised that investment banks have earned approximately $1 billion in fees over the past three years but today the bank still needs to raise $5 billion equity capital and the bank is valued on the share market at $747 million.

Can you spot the riskless winners here?

The usurious approach to bank restructuring of applying much bigger leaches will result in excess blood-loss in my view and the bank’s will fail without state intervention in the ownership of the bank(s).

Now is the time if intervention is to occur otherwise the Italian taxpayers will have recently handed over this additional $250 million to the investment bankers shortly before accepting the equity risks of the whole bank anyway.

Are these investment bankers unwisely keen on public revolt?

Ever The Optimist– Electronic card spending on hospitality in July was 18 percent higher than a year earlier at $925 million. +18% is good in any language.

That’s what we like to see; more tourists spending more money.

By happy coincidence ‘we’ spent less on fuel given the new declines in the price of oil, so I am hoping that rising tourist spending and lower spending on fuels helps us toward much needed trade surpluses.

ETO II – Spark CEO Simon Moutter promoting a need for New Zealand’s largest businesses to support more ‘early stage’ businesses and setting an aspirational goal for himself to help achieve a $100 million funding vehicle in support.

Over the past two years I have been attending some venture capital sector meetings to understand ‘start up’ business funding which typically involve smaller sums (less than $1 million) which can, and probably should, come from a combination of wealthy risk takers.

However, one of my observations is that the start-ups that show signs of succeeding quickly, but still ‘early stage’, need quite large sums of money (multiple millions of dollars) thereafter yet they have not become large enough to attract the attention of the larger NZX firms or investment banks.

I’d like to see Moutter succeed with his aspirational goal and to ensure that the fund’s leadership dove-tails with the many venture capital organisations that already exist.

ETO III – Milk price futures are rising in price.

This provides some hope that the Global Dairy Trade auction may enjoy another lift in price next week.

Astute farmers are likely to now have set up accounts with brokers for buying and selling Milk futures contracts to protect more of their future income at known prices.

Rather than wait solely for validation at next week’s auction farmers would be wise to make use of futures contracts to lock in acceptable pricing early.

Investment Opportunities

Westpac Bank – the offer of Tier II subordinated notes is now open. It is the first offer of its kind by WBC in NZ (although the issuer is Westpac Australia).

The interest rate until 2021 has been set at 4.695%.

Those with a firm allocation from us should now have their application forms in with us, or have notified us of when to expect it. The offer closes on 26 August.

Z Energy – has now announced that it proposes to offer a new bond (presumably senior again) to replace the bond maturing on 15 October 2016 (ZEL010).

There are no more details at this stage but you can be sure it will be a longer-term bond (5 years or longer) and that the yield offered should reach, or slightly exceed 4.00%.

We have started an email list for this offer which investors are welcome to join.

Kiwi Property Group – We expect this proposed offer of senior bonds to return to the market at some point.

Other bonds – there are bond maturities from the following companies between now and Christmas (too early to use that word – Ed) and clearly we hope they will offer investors new bonds to consider: ASB, BNZ, Sky TV, Air NZ, Trustpower, Auckland Airport, Turners Ltd and bonds issued to wholesale investors from Genesis Energy, Mercury, Dunedin City and NZ Post.

Shares – discussions in the media suggest that we may see Initial Public Offers of shares from King Salmon and Perpetual Guardian Trust in the last quarter of 2016.

Travel

Kevin will be in Dunedin on 26 August.

David Colman will be in Palmerston North on 17 August.

Edward is in our Wellington office (Level 15, ANZ Tower, 171 Featherston St) on Tuesdays, available to meet new and existing clients who prefer to meet in Wellington - by appointment please.

Edward will be in Christchurch on 23 August.

Investors wishing to make an appointment are welcome to contact us.

Michael Warrington


Market News 8 August 2016

Could it be that Donald Trump does not want to be President?

His behaviour recently has become illogical if he wants to be elected, and this takes into account his unusual method of succeeding in becoming the nominated Republican candidate, to the surprise of most people.

Donald Trump is a brand, not a good public leader.

I don’t think he is a complete fool though (just partial – Ed), I just think he has been participating in the process for his own ego and with business interests as his fallback position. I think Trump is as surprised as everybody else that he is in this current position of being shortlisted for President of the US.

Trump knows how constrained he would be if he was elected as President and a constrained ego is anathema to Donald Trump.

If I am correct that he does not wish to be elected as President of the US then he will likely pick a fight with the Republicans prior to the election and hope that he loses 10-20% support from this grouping as a result.

This might result in as many as 65% of the wider population voting for Hilary Clinton as President (grudgingly – Ed).

Trump will already be thinking of where to assign blame if he loses and each decline in the polls will reduce his willingness to spend any personal money on his campaign.

If 65% of all voters choose Clinton then she may receive the highest proportion of the Electoral College vote since Ronald Reagan (90% in his first election). Only George Washington secured 100%.

By the time a Clinton victory becomes clear I suspect Hilary will only be interested in beating her husband’s performance of about 70%.

In a nation of over 300 million people it is a surprise that ‘they’ seem keen on touching various bases for the type of President sought (Father, son, white, black, East, West, North, South, war hero etc.) but now it seems to be the time for choosing the first female President and simultaneously the first wife of a prior President.

Once the polls swing strongly, which has already started, market volatility might drop as US companies gain confidence and return to long term decision making.

INVESTMENT OPINION

 

RBA Cuts – The Reserve Bank of Australia has cut their official cash rate by 0.25% to 1.50% continuing what seems to be an irreversible trend by central banks.

Financial market pricing implies that the majority in financial markets expects another 0.25% cut by November, and frankly why not continue thereafter?

The RBA governor’s media release can be read here http://www.rba.gov.au/media-releases/2016/mr-16-18.html and it is very similar to those issued by the RBNZ. His closing quote was – ‘Taking all these considerations into account, the Board judged that prospects for sustainable growth in the economy, with inflation returning to target over time, would be improved by easing monetary policy at this meeting’.

The governor could have used the bold item (my emphasis) after every cash rate review for the past few years, but on each occasion the statement has been proved as hopeful rather than accurate.

The RBNZ is guilty of exactly the same thing. A recent research item from the ANZ disclosed how the RBNZ has presented inflation forecasts rising back to the centre of the target range on every occasion of the past three years but actual inflation has never gone close to the forecasts, usually falling further.

I wonder what the RBA and RBNZ will do when the facts don’t change.

Plenty of people find reasons to criticise John Maynard Keynes economic strategies but it is hard for central bankers to go past this quote at present: ‘When my information changes, I alter my conclusions. What do you do, sir?’

To be fair to the RBNZ they are not alone in making such hopeful forecasts and unlike private industry forecasters the RBNZ has a bias to present a case to the Minister of Finance that they believe their current actions will result in them meeting their obligations under the Policy Targets Agreement.

The reality is that it is not working and we are reminded of how little control we in New Zealand have over some of our most significant economic and financial price pressures.

I am beginning to ponder just how disinterested investors and traders are in the musings and conclusions of central banks. I saw an amusing photo online of the US Federal Reserve chair Janet Yellen speaking on a television (the television was on the wall of the US Stock Exchange) and not a single floor trader was looking at her.

Throughout my career little was more influential than commentary from the central bank as we searched to understand strategic changes or influences to financial market pricing, but today we all seem to be taking less notice. I certainly don’t lose any sleep if I miss a live announcement, reading the content later (or video replay) because the announcements seem to be less and less influential.

I guess that makes sense as we approach 0% interest rates.

The most interesting central bank change recently, from my perspective, has been the ongoing development of macro-prudential tools to influence credit use (property lending in particular) and the clear expectation that they will begin to be effective.

I like that the RBNZ is introducing more tools to seek desirable outcomes. Certainly moving our cash rate around was becoming less and less effective and thus less relevant.

Sadly the lower OCR has had a negative effect on our clients but tighter macro-prudential tools do not benefit them.

Actually, there may be a little hope for investors.

The most interesting reaction to the 0.25% interest rate cut in Australia was that banks have reduced mortgage rates by only 0.10%-0.14%, that’s right banks’ are now competing in 0.01% increments, but the good news is that some deposit rates were increased (by as much as 0.50%)!

With difficulties anticipated in accessing some international funding markets the Australian banks appear to have kicked off something of a funding war domestically. They are behind the NZ banks in this regard, which aggressively increased deposit ratios two years ago, but I suspect NZ banks will hop back onto the front foot again to maintain high levels of domestic funding here too.

We should expect similar responses here in NZ next week (11 August) when our OCR is reviewed and I am sure the RBNZ will not mind one iota if there is a widening of the margin between the OCR and deposit rates (returns to savers) and mortgage rates (costs for borrowers).

Indeed central banks should be pleased to see an interest rate scenario develop that rewards well-behaved savers and penalises any person carrying excessive debt levels.

NZ banks are obliged to keep their Core Funding Ratio above 75% and retail deposits count toward this measure. Higher international borrowing costs and evidence of lending growth may see a return to higher deposit interest rates as domestic banks compete to attract our attention.

To some extent we are already seeing this happen and you’ll not hear any protests about such a development from investors.

Bank of England – Coincidentally in concert with the RBA and soon the RBNZ, the Bank of England cut its ‘Bank Rate’ (equivalent of our Official Cash Rate) by 0.25% down to 0.25%. The next stop is 0.00% like others before them.

The summary headline was:

‘a 25 basis point cut in Bank Rate to 0.25%; a new Term Funding Scheme to reinforce the pass-through of the cut in Bank Rate; the purchase of up to £10 billion of UK corporate bonds; and an expansion of the asset purchase scheme for UK government bonds of £60 billion, taking the total stock of these asset purchases to £435 billion.  The last three elements will be financed by the issuance of central bank reserves’.

So, this is a rate cut followed up with a bond-buying (‘money printing’) programme. The astute among you will have noticed that the BoE’s new bond-buying programme is twice the size of the NZ government’s total debt on issue.

Using back of the envelope maths, the NZ government debt, owned by real investors, equates to about NZ$6,750 per person (4.5 million people in NZ) but the BoE will own NZ$12,500 for every member of the UK population (64.5 million people) using tax payers money to support the position.

The market yield on UK 10 year Gilts (government issued bonds) fell to 0.62% and there is every likelihood that it will decline to near zero percent (or negative) like the a dozen other relatively robust economies in Europe. BREXIT hasn’t removed the appropriateness of describing the UK as a robust economy.

This new lurch lower in short and long term interest rates makes it very hard for investors to sell any assets at all! (Disclaimer – please talk to your financial adviser about your specific situation before putting your portfolio back in the drawer and saying ‘Honey, Mike says don’t sell’).

Investment News

US Employment – July employment was stronger than expected at +255,000, which saw share markets return to previous highs, and set new highs in some cases.

Bond yields moved higher and commentators ponder the US Federal Reserve being able to return to plans for increasing the Fed Funds rate.

Increasing employment is good news, but to put it in perspective US participation is currently at about 60% of available population yet by comparison NZ sits at 69%.

I hope employment growth is sustainable because it is desperately needed and in more places than just the US.

Precinct – PCT has successfully negotiated some very long term property leases with the government confirming a 14.6 year agreement over 68,000 square metres of property in Wellington.

This is one advantage that the largest property owners have in that their control of larger property supply enables them the best negotiating position with the largest tenants, and in this case the country’s strongest tenant too(financially speaking).

PCT’s Weighted Average Lease Term has lifted to 7.4 years (9.5 years on Wellington assets) and should increase further still based on anticipated negotiations on other properties.

The lengthening of the leases, especially in Wellington, will ensure that PCT has the funding available to develop the Bowen Campus, which seems very likely to enter the government estate long into the future.

There is clear value in long(er) leases, recall that the fix for the overspend on the Ministry of Health building in Wellington was resolved when the government agreed to a lengthy extension to the previously agreed lease; no extra cash was required up front.

WALT is an important metric for property investors and this new trend to increasing WALT is a good development for property investors, especially those with large pools of high quality property.

Infratil – IFT has gone one better than PCT and invested in Australian National University student accommodation with a 30 year lease agreement!

IFT has again co-invested with the Commonwealth Superannuation Corporation, which I view as a very wise strategy when negotiating long term commitments (assets) with Australian central and state government and its agencies.

Last month these two announced a co-investment in providing locations for cloud computing resources for central and state government leases.

The only emotional frustration here is that IFT is not finding such opportunities for investment in New Zealand. (And that the NZ Social Infrastructure Fund wasn’t invited to co-invest – Ed).

I wonder what the ANU and Australian education sector sees as reason to invite external investment that NZ universities are not yet seeing.

Fees– Kiwisaver doesn’t feature in our ‘Scope of Business’, other than to encourage all investors to embrace investment subsidies. However, Sam Stubbs launch of a low fee Kiwisaver (Simplicity) deserves applause.

A few months ago I couldn’t help but offer another opinion ‘outside our Scope of Business’ when I lamented that soon the largest Kiwisaver accounts would pay out more in fees than those investors received from government and employer contributions.

I proposed that we needed to see competition based on lower fee structures inspired by lower expense business models (which Stubbs achieves through contracting out to the world’s largest fund manager – Vanguard) and through competing for the largest Kiwisaver account balances.

As it happens, the NZX (and SuperLife) also offer a low fee model Kiwisaver but Stubbs has turned the torch up on cutting fees further.

Good on Sam Stubbs, doubly so on the basis that he is reported as not drawing a salary from the venture. Simplicity will operate as a not for profit with surpluses directed to charities nominated by investing clients.

Sam Stubbs is essentially speaking our language, regardless of scope, by highlighting that fees erode an investor’s net return and yesterday’s fees are all out of proportion with today’s returns.

Rakon – The NZ Shareholder’s Association would be pleased if shareholders in Rakon appointed them as proxy for the next meeting, giving them discretion with the votes too, and ensuring maximum leverage for the NZSA to negotiate with the RAK board over changes that it feels are necessary.

I regularly encourage retail investors to exercise their votes and if not keen to do so they should pass them on to a proxy such as the NZSA who will act in your interest at the meeting.

Consistent with this I have also encouraged share investors to consider joining the NZSA as a member both to support them, as they support members, and to gain access to their information database on various companies.

Here is a link to their website: http://www.nzshareholders.co.nz/

I’ll be interested to see if NZSA agitation at RAK is effective this time.

Ever The Optimist– The Hurricanes are finally on the scoreboard as champions of Super rugby. Now we need a winning season from the Phoenix and we can return to the calls for a well-financed roof over the stadium (and heated seats – Ed).

ETO II - Motor vehicle registrations in the first seven months of this year are 6.2 percent ahead of the same period last year at 80,704.

No wonder it is taking longer to get to work in the morning.

ETO III – The horticulture industry is enjoying strong gains and a press release from Pipfruit NZ reports that growers will plant another one million trees.

This surge in demand sees a major Nelson nursery with a three-year back order for some rootstock and it is certain that all other major nurseries are enjoying the same experience given the length of the back orders.

Investment Opportunities

Westpac Bank – the offer of Tier II subordinated notes is now open. It is the first offer of its kind by WBC in NZ (although the issuer is Westpac Australia).

The interest rate until 2021 has been set at 4.695% per annum.

It may not be a new product type but it does bring some diversity to the portfolios of those who include subordinated bank securities.

As a reminder, Tier II securities rank behind bank deposits and senior bonds but ahead of shareholders and Tier I securities on a bank balance sheet.

The offer matures in 10 years with the potential for repayment after five years (subject to regulatory approvals).

Kevin Gloag has produced a research piece on this offer and a reminder of the structure of Tier II bank capital. It has been published on the Private Client page of our website.

Kiwi Property Group – We expect this proposed offer of senior bonds to return to the market at some point.

Travel

Kevin will be in Dunedin on 26 August.

David Colman will be in Palmerston North on 17 August.

Edward is in our Wellington office (Level 15, ANZ Tower, 171 Featherston St) on Tuesdays, available to meet new and existing clients who prefer to meet in Wellington - by appointment please.

Edward will be in Christchurch on 23 August

Investors wishing to make an appointment are welcome to contact us.

Michael Warrington


Market News 1 August 2016

If Michelle Obama stood for President of the US, as a late entry independent candidate, what would her margin of victory be?

INVESTMENT OPINION

 

Woolworths – This is a clear example for investors and business managers to remember the wisdom of Robert Burns when building their business or investment empire; ‘the best laid plans of mice and men often go awry’.

Woolworths (WOW) are in the midst of an honest assessment of their performance, or under-performance, and the findings disclose a need to acknowledge and write off losses on many investments and to also exit some of their core supermarket outlets.

Quite why they have two Countdown stores in Johnsonville (near me) about 200 metres apart is beyond my knowledge, especially with another major store only 2 kilometres along the motorway in Tawa. One will surely have to go during this clean out of excess.

The latest WOW headline that caught my attention was the write off of AUD$309 million on the value of EziBuy, which WOW bought for NZD$350 million in 2013 from the founders (and a Private Equity firm – Ed).

The honesty from WOW about the write off was refreshing – ‘following the recognition that the expected synergies between these two businesses have not been realised, and, in many cases, have resulted in dis-synergies for both businesses’.

Mind you, a near 100% write off is a disaster in anyone’s language and the pre-purchase ‘inspection’ grossly over-estimated the possible and probable synergies. Perhaps WOW placed too much reliance on the information provided by the private equity vendors of EziBuy?

Mind you, to WOW’s credit they once sold a well-known business (Dick Smith) to a private equity investor, but that’s another story (of ultimate failure – Ed).

The message is to take with a grain of salt the financial victories proffered in shareholder voting documents if they are anchored in merger synergies, post takeover.

Actually, there is a second message for investors, and business managers’, relating to the term ‘risk’; the outcome is seldom likely to be as good as you hope, or expect.

Liquidity– We often discuss the value of liquidity to an investor even though one hopes to never need that liquidity based on intentions to hold investments for long periods of time, or until maturity in the case of most fixed interest items.

Nonetheless, liquidity is valuable as it ensures one’s ability to generate cash, if required, or to exit an investment that is no longer wanted be it for strategic or underperformance reasons.

I have occasionally described access to liquidity for an investor’s portfolio as being worth as a much as 0.25% per annum because it supports one’s ability to execute strategic changes between asset classes to try and keep returns up, and importantly it enables one to exit a bad investment if one is spotted as such.

An extra 0.25% across a portfolio is increasingly meaningful in current market conditions.

Regular readers will know of our view that investors should always hold a large sum in an emergency fund at a bank ‘on call’. Investors should also hold aside cash (or short term deposits) for known or probable expenditure over the next 12-24 months. Next we encourage investors to hold a high proportion of tradeable investments, which can be sold, subject to the market depth for the asset type.

To hold an illiquid asset is to confirm that there are no circumstances under which you can imagine needing that amount of money forcing the sale of that particular asset.

The first step to ensuring you have liquidity at all times is to hold plenty of callable cash in the bank. Thereafter you are reliant on the market to buy assets from you if you find yourself in the position of needing to sell an investment early.

Financial markets charge a price for liquidity, a profitable spread between buyers and sellers, a price that is set as a function of the capital that a trader must hold available multiplied by the marginal profit sought by them throughout a year. These traders try to profit by temporarily buying and selling long-term assets using cash held for that purpose.

The more liquid an asset is the lower the price of liquidity shall be.

A government bond can easily be bought and sold any day given the high volume of participants in this market, so the price of liquidity may only be 0.01%. This is a bargain compared with my assumption of liquidity having a 0.25% per annum value to a portfolio (although the running return on a government bond is more than 0.25% below other investment risks).

By contrast residential property incurs a one-time transaction cost of 3.00% - 4.00% and possibly tens of thousands of dollars between buyer and seller expectations, depending on market conditions.

Whatever the asset is there must be a profitable spread between buyers and sellers for traders to, on average, make a profit from participation in that market.

It is this concept of sufficient profit for traders that got me thinking about this subject.

A statement by the Bank of International Settlements and comments from John Mauldin on the subject raised their concerns that market liquidity, especially in the biggest markets, isn’t as good as it seems and they seem to be pointing their finger at the high frequency traders (HFT) for damaging that liquidity rather than enhancing it as I am sure they would claim to do.

In a large market with high activity volumes, such as the New York Stock Exchange, you could be forgiven for believing that the HFT add liquidity and thus add value to a market.

I share the BIS / Mauldin view that HFT remove liquidity from the market.

HFT are, in my view, trade and profit from inside information not risk. They are not earning a profit spread based on a willingness to accept risk between buying and selling on a market, they are using speed to spot the buying and selling activity of others and then jumping in front of such trading to extract their ‘tax’ (assured profit margin).

The fact that successful HFT make very large profits from market participation without risk is evidence that they remove value from the market and doing so without risk has become a negative influence on true market depth and thus liquidity.

HFT do not want to buy from a seller to provide liquidity and then wonder about exiting the newly purchased risk at a profit, once HFT spot this seller they want to sell too with the clear intention of getting in front of the seller to profit from the impact of the sale on the market (front running, using inside information).

One of the points made by the BIS was that the scale of the Global Financial Crisis was made worse by the fact that traders, who provide liquidity, were not sufficiently well rewarded and thus were not present when the market needed them the most forcing governments and central banks to step in and provide necessary liquidity to many markets.

When you look at the ongoing strategy of the central banks to provide limitless volumes of overnight cash loans and to buy as much as 30% of all strong senior bonds on issue you’d have to agree with the BIS about government and central banks now being the liquidity providers to the market.

Whilst most of this liquidity came in the form of short and long-term interest rate market support, don’t forget there were also foreign exchange intervention, equity intervention (buying banks and motor companies!) and finally insurance risk intervention. If they had intervened in commodity markets they would have covered almost all asset and risk types!

It is a certainty in my opinion that central banks and governments will lose money, rather than profit, from this provision of market liquidity; yet another distortion on the pricing that we should be confronting in the markets.

The BIS optimistically hopes that we have learnt our lesson from the poor liquidity of the GFC and that we will agree to pay more for liquidity in future to support better market liquidity. Don’t count on it. It has never succeeded in my time in financial markets when attempts have been made to pay for the provision of market liquidity.

With that in mind it should clearly highlight to investors the importance of self-managing their own liquidity profile (a mix of cash, short term deposits, strong bonds across many dates, shares in dominant companies that are traded often) and never becoming dependent solely on liquidity provided by the market place.

A well-planned portfolio will result in less change (trading) minimising transaction expenses, which have an increasingly detrimental impact on net returns in this low return environment.

Private Debt Levels – There was a story last week trying to explain why credit card debt levels had dropped for what seemed like the first time ever.

Many commentators who were approached offered rational reasons why debt on credit cards had declined with the main reason being that the same debt was being accessed and increased overall elsewhere.

One contributor that didn’t reach the list of ideas for the article was Peer-to-Peer lending. Harmoney’s growth to the point of assisting with $280 million of lending implies part of the shift for sources of Private Sector Credit.

Frustratingly I share one commentator’s view that private debt levels were reaching the point of despair or unaffordability.

When writing this paragraph I logged into Harmoney to look at current borrowers and found two ‘A rated’ with the following anecdotal ‘keep borrowing more’ approach to life:

First loan – The borrower (50-59 age bracket) repaid a $10,000 loan for ‘wedding expenses’ early and was asking to re-borrow $30,000 under the heading of ‘Wedding Expenses’. The status of the borrower was ‘Married’.

Presumably the loan is for a child’s wedding.

Does this mean the party got out of control expense-wise? Or perhaps wedding number one failed already and the person is trying again a few months later?

Second loan – borrowed $25,000 for debt consolidation.

This loan has now been repaid and they wish to re-borrow $30,000 for, yes, debt consolidation.

They either failed to consolidate all of their debts, or failed in their ambition to use a lower overall cost of debt to reduce their indebtedness.

Globally the volume of unaffordable debt is a problem, but we mustn’t kid ourselves into thinking New Zealanders are in good financial shape, because at a personal level we are not.

New Zealand has the 7th highest level of household debt in the developed world, measured as a percentage of our economy. Unfortunately not a list you want to feature prominently on. Australia, and surprisingly Switzerland, head the field for household debt.

Investment News

Trade Deficit– The fruit story below (ETO) also disclosed our annual trade deficit as being $3.3 billion, again…

We are failing in our attempts to achieve much needed, and recurring, trade surpluses, which we desperately need to begin repaying our excessively high proportion of debt (privately held, not government debt).

A $3.3 billion deficit is $1,400 per employed person per annum, which seems to be about 3% of average after tax income. I am not suggesting that people who find it hard to save any money instantly save $1,400 but it would be great if they found a locally supplied alternative.

One day I hope the trend toward electric cars will help tilt our consumption from imports (oil) to domestic energy (electricity). This will happen but it is a slow change item.

I tried to think how I would achieve such a rate of change in our house, which is in a position to save money. Buy fresh food from local growers, drink local wine, delay technology upgrades, always upgrade to the most efficient vehicle for the purpose when change occurs, buy products and services from businesses that are predominantly owned by New Zealand tax residents (keep their dividends in NZ).

It’s not as easy as I thought to save a meaningful amount (i.e. not imported).

If Pine weatherboards are a similarly priced cladding material to the internationally manufactured products I hope the government is encouraging its use again in Housing NZ. We know the grief that many inferior products have caused huge numbers of people during the leaky homes problems.

The hardest things in life are often the best; so don’t give up on the strategy.

Could you spend $1,400 less per annum on imported products, or export $1,400 more than you currently do? (Or help an exporter to achieve it).

EROAD – I think the quote I am thinking of is ‘every long journey begins with the first step’ but in the case I wish to say ‘every long journey begins with the first roll of the wheel’.

More accurately, ‘journeys end will be achieved if the wheels continue to roll’.

With a little bias (being a shareholder) I was pleased to see that our company from little New Zealand has been accepted as a partner of the American Trucking Association, the largest association in this industry.

The partnership is clearly more than a rubber stamp or a subscription fee because the ATA President and Chief Executive released a brief comment about EROAD becoming a partner and presenting the EROAD website under the http://www.atabusinesssolutions.com/ own website for business solutions for truckies.

EROAD sales people still need to do the ‘leg work’ but it is clearly a positive development to have industry doors opened rather than closed.

XERO is proving that a business initiated in NZ can become a global service provider so I hope that EROAD (and other small NZ businesses) can be similarly successful.

Flick Electric – Speaking of small NZ businesses with international ambitions, Flick Electric (a very competitive electricity retailer in NZ) must take heart from a recently released nationwide survey in Australia which found that retail energy consumers believe they are not receiving good value for money from the sector.

This consumer sentiment aligns with an opinion from the head of the Australian Competition and Consumer Commission, Rod Sims, who said he was on ‘the verge of becoming anti-privatisation because the sale of electricity companies had created unregulated monopolies’.

Sims also stated ‘I've been a very strong advocate of privatisation for probably 30 years ... I'm now almost at the point of opposing privatisation because it's been done to boost proceeds, it's been done to boost asset sales, and I think it's severely damaging our economy’.

I know that Flick Electric is expanding quickly in NZ and has aspirations to expand into markets like Australia so they will be smiling at the opportunity to compete given the view of both the Australian regulators and consumers.

Disclosure – recall that I have an investment exposure in Flick Electric.

Ever The Optimist– Fruit is now the country's fourth-largest export commodity, having jumped 31 percent ($617m) to $2.63 billion for the 12 months to 30 June 2016.

The $617m increase was almost three times the size of the increases enjoyed by forestry and meat exporters (although all increases are great news).

The fruit industry is now approximately 25% of the value of dairy, and rising, but I’ll wager they introduce far less damage to the downstream waterways of NZ.

It seems likely that Fruit will close the gap further to dairy because they are focused on delivering the price premium items to market unlike meat and dairy which promote themselves as low-cost producers (this is questionable).

The good Doctor was right, ‘an apple a day keeps the Doctor away’, or more accurately for this sector it keeps the banker at bay.

David Hisco will be a fan of the NZ fruit industry.

Investment Opportunities

Westpac Bank – has announced an offer of Tier II subordinated notes in NZ, being the first offer of its kind by WBC in NZ.

It may not be a new product type but it does bring some diversity to the portfolios of those who include subordinated bank securities.

As a reminder, Tier II securities rank behind bank deposits and senior bonds but ahead of shareholders and Tier I securities on a bank balance sheet.

The offer matures in 10 years with the potential for repayment after five years (subject to regulatory approvals).

The equivalent bonds on the market from the likes of ASB and BNZ imply that the yield to expect from WBC is between 4.75% - 4.95% for the first five years.

Kevin Gloag has produced a research piece on this offer and a reminder of the structure of Tier II bank capital. It has been published on the Private Client page of our website.

Investors are welcome to contact us and join our list.

Wellington Airport – issued $60 million of a new senior bond last Friday maturing on 5 August 202 and set the interest rate at 4.00%.

Thank you to all clients who participated in this offer with us.

Co-Operative Bank – closed its Tier II subordinated bond last week.

Again, thank you to those investors who participated in this offer through us.

Kiwi Property Group – We expect this proposed offer of senior bonds to return to the market at some point.

Travel

Kevin Gloag will be in Christchurch on 11 August and Dunedin on 26 August.

David Colman will be in Palmerston North on 17 August.

Edward Lee will be in Christchurch on 23 August

Investors wishing to make an appointment are welcome to contact us.

Michael Warrington


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