Chris Lee & Partners Ltd

Market News 25 June 2018

Last week a reader was more than a little unhappy that I could lend any column centimetres complimenting President Trump.

I think the person overlooked all of the conditional comments in my paragraph and didn’t want to acknowledge that the meeting in Singapore was extraordinary.

However, the difference of opinion was the definition of perspective and I respect theirs.

I prefer to avoid political judgments because other than within NZ I don’t get a vote, but politics and central bankers have a huge influence on investment tides, and thus decision making, so we need to review them to consider the impacts.

For all of Donald Trump’s unquestionably strange methods I am hanging on to an important litmus test; New Zealander Chris Liddell.

He remains in the White House. His responsibility seems to be rising. He has a sharp mind. He doesn’t need to be there for his ego, nor the pay cheque. So, in my opinion he is there to achieve something, for America (as it happens).

If Chris thought Trump was a destructive disaster I think he would move on. It appeared to me that he moved on from General Motors on a point of principle, so I’d expect the same principled approached here too.

I know that the sycophants in the White House are many, but Chris isn’t one of them.

If Chris ultimately departs the White House quietly it is another black mark for Trump.

If he goes down in a blazing disagreement (‘you’re fired’ – Ed) it’s a clash of strongly held principles.

But, if Chris is still there for the 2020 Presidential election there is more to the current Presidential strategy than we may recognise.

INVESTMENT OPINION

Genesis Future Pricing – Many people considering investment in the new Genesis subordinated bonds (GNE050) have been asking about the risks of non-repayment at year five (2023) and what happens to the interest rates at that point if they do not repay.

The technical speak is presented in the offer document (PDS), which the enquiries confirm is not much fun to read.

So, I’ll tackle the topic for a wider audience here for you.

First, it is important to note that the risk of forced retention of the GNE050 investment between 2023 – 2028 is low. This scenario is as undesirable for Genesis Energy as it is for you.

The probable outcome is the same as you are witnessing today; Holders of the old GPLFA (and the market of new investors) have been approached by Genesis and offered a new investment – GNE050. If the GNE050 offer is successful, the old GPLFA will be repaid and not forced into the second period.

With a little imagineering (hat tip to Walt Disney) you can see through the looking glass that Genesis will likely offer a GNE060 in 2023, at competitive pricing to attract investors, and if successful they would repay the GNE050 that was issued now (2018).

If Genesis was in financial difficulty, maybe this new issue of GNE060 wouldn’t occur, but I’ll let you place a (non) probability factor on this subject.

What if credit margins had lifted significantly by 2023 so re-borrowing new money was relatively more expensive than retaining the GNE050 on issue?

Technically this is possible, but it would be a financially cynical approach and would, as they say, soil the nest that Genesis sleeps in, so this seems unlikely.

Genesis needs the equity content provided by these bonds (more so than they are willing to pay it – Ed) so unless they build their retained earnings (equity) over the coming five years they won’t be well positioned to soil the nest.

A few clients asked me to forecast the interest rate they would receive in 2023 if Genesis did not repay.

This was a little speculative, and of little value I thought, but the number of people asking meant that many wanted a practical understanding of the situation.

Tomorrow Genesis will set an interest rate for GNE050, probably between 4.65%-4.75% being the benchmark rate (5 year swap rate close to 2.65%) and a credit margin (say 2.00%).

If in 2023 Genesis did not manage to repay the GNE050 bonds the interest rate reset for the period between 2023-2028 would be a combination of:

(A) 5 year benchmark swap interest rate*;

(B) Today’s credit margin (+2.00% from example above);

(C) An additional credit margin of +0.25%.

One fear was that if nominal interest rates increase Genesis will not repay the current bond, so as to save money?

‘No’, because the nominal interest rate will be reset in 2023 for the period until 2028; you will not be left with a bond yielding 4.65% - 4.75% from today’s market settings. If interest rates are about 10% then this will drive the interest rate payable by Genesis.

In my example above, if the nominal benchmark interest rate was 10.00%, the interest rate payable by Genesis on the GNE050 second period would be 12.25% p.a. (A+B+C).

‘Mike says’…

Repayment in 2023 is a probable event; and if not,

The interest rate set for the period 2023-2028 will change relative to market interest rates that prevail in 2023.

*If you have lost our previous descriptions of the interest rate swap market perhaps you could visit Investopedia for a quick reminder, but it is an interest rate environment in financial markets, used as a benchmark for interest rate setting on most fixed interest products.

Kevin Gloag has written a research piece for this bond offer. Clients receiving financial advice services from us are able to access this research on the login page of our website.

NZ’s Global Businesses –Regardless of their delisting from the NZX, Xero (XRO) continues to cut a successful path with its global business, last week reporting that it is targeting 1 million customers in the UK, now its second most successful market.

Rod Duke, and the XRO board, was correct when he stated that the pure ASX listing would better expose the business to a wider capital pool of investors, witnessed by the surge in XRO share price following that wider visibility.

Interestingly if Xero does reach its cash flow neutral position soon, and then profitability, it may have no need for future capital raisings.

Another NZ business enjoying international success, this time in the US where many of our NZ businesses struggle, is PushPay (PPH).

PPH had been contemplating a US listing to expand the access for more institutional investors to join its register, which was tightly held up until last week.

The US listing strategy changed (was cancelled) last week when a founder shareholder decided to exit the register (9% shareholding).

The market’s immediate concern was why would this person leave (personal reasons, seemingly unrelated to corporate strategy) but I agree with the alternative assessment that the departure of Eliot Crowther has facilitated more breadth in the share register for PPH, which is healthy for market liquidity and access to additional capital, should it be required.

Securing the involvement of nine new professional investors in PPH, whilst listed on the NZX, is a commendable outcome for the company. Without the need for a US listing the company has probably avoided a likely obligation to raise new capital that is not required and the large fees that would have been demanded by a US investment bank for the listing.

Eliot Crowther deserves to enjoy his success and new personal priorities.

The NZX, and wider international investment community should be grateful to Crowther for his decision.

Other young New Zealanders should be inspired by Eliot Crowther, Chris Heaslip and PPH.

Investment News

Scams – It was brave of the person who approached the media last week to explain they had been scammed out of $525,000.

It was deflating to have the Commission for Financial Capability respond by saying that sadly this is a modest sum relative to others and a very frequent occurrence.

The person who was scammed had been cold called (an unexpected call from a sales person) and progressively groomed into paying over money. Logical decision-making processes are undermined by greed, a behaviour expected and prayed upon by these callers.

It seems selfish of me to say but financial advice is available to the public, so I urge them to use it.

We spend a lot of time poking holes in the excessive fee structures within the finance industry, but those fees are a small fraction of the $525,000 lost by this individual.

If the person who lost the money had breached their preference to not pay industry fees, whether they were hundreds or thousands of dollars, the result would have been very different.

Your money was too hard-earned, and saved, don’t give it away via easy exits.

If you did not initiate the contact with the caller, question the reason for the call. ‘What’s in it for them?’

If you’ve had kids, think of all the stories of justification from their younger days as you listen to the salesman on the line.

Consider the fact; in a world of 5% - 8% returns why would someone call me with an easy 15% - 100% return?

If you had a near certain 15%-100% opportunity would you tell a stranger?

Fund managers and brokers earn 1-2% on transactions or managed money. Why would they share opportunities for a certain 15%-100% return?

You know none of it makes sense. Trust your instincts when your decision is about to be fuelled by greed, disconnect.

Proactively call a known financial adviser. Call the Financial Capability Commission. Call your Nana. Ask your mate. All of them will tell you to back away.

As it happens I received a call last week from a young man who had been cold called to access a share listing for a recognised Chinese company brand.

I applaud his willingness to ask.

I shot the idea down like an unwanted disease.

I hope he heard my message through the potential greed. I was very clear.

Do not accept cold calls. Reject the greed urges. Find the strength to overcome the manners you were taught and bid the caller good bye, early in the conversation.

If you are not already connected, please connect with the financial advice community.

Getting Messy – The trade war behaviour is ratcheting up, and warrants some more attention from investors, especially those with high proportions of their portfolios invested internationally.

Retail – Costco seems to be putting a fly in the ointment of those who would declare retail to be dead, because they are seeking to establish their business in little old New Zealand.

We are just a village to Costco. What’s up?

Costco has ‘warehouse scale buying power’, and is a membership-based discount retailer.

Don’t we have one of those already?

It would seem that there are still profit margins in retail, subject to scale, good customer service and excellent inventory management and sufficient room for a new player to try and be disruptive.

The share price chart for Costco confirms that ongoing success is possible.

I wonder if Costco will disrupt online retailers (international product sourcing) more than the likes of the Warehouse locally because their share price has been rising the fastest during the recent period of an explosion in online retail options.

I think retail remains very difficult to invest in given the volatility of performance across the sector, but I’ll be interested to see how this plays out.

Cryptocurrencies – Don’t swap all your NZ dollars for crypto currency just yet.

The Bank for International Settlements recent review states that the promise of crypto currencies to replace trusted institutions with distributed ledger technology is unproven and unlikely.

Looking beyond the hype, it is hard to identify a specific economic problem that they currently solve. Transactions are slow and costly, prone to congestion, and cannot scale with demand. The decentralised consensus behind the technology is also fragile and consumes vast amounts of energy.

I might add that it has been as prone to attack and theft as any other payment medium.

It is also interesting that in a world that wants to sell us more technology, which operates at lightning speed across fibre, distributed ledger technology still takes many minutes to validate transactions.

Nonetheless, the BIS acknowledges that distributed ledger technology (BlockChain) could have promise in other applications and recommend that policy responses are needed to prevent abuses while allowing further experimentation.

I have long viewed the greatest value for an economy, sourced to crypto currency development, to be the use of BlockChain across data management and transaction recording and look forward to seeing this develop.

Ever The Optimist – Lamb prices are on a surge ($7.75/Kg, with a chance of $8 again) and this is great news for sheep farmers and for multi-product farmers who run a few in the hills for diversity.

Investment Opportunities

Genesis Energy – new subordinated Capital Bond offer, of up to $240 million (code GNE050), to replace its old version of the same bond (GPLFA) is underway.

We bid for an allocation tomorrow, so it’s the last chance to join the list right now. (Knowing if you wish to invest with cash, or roll the old GPLFA bonds is helpful).

The offer document is available on the Current Investments page of our website, expanding on the terms of this 30-year bond, with possible reform after 5 years.

GNE has helpfully offered the ability to use old GPLFA bonds to pay for applications into new GNE050. Cash can also be used for new investment.

GNE will set the interest rate tomorrow (not less than the minimum of 4.65%)

More bonds – We have been told to expect several more bond issues after the Genesis offer.

The fastest way to hear about new investment offers is to join our ‘Investment Opportunities’ (New Issues) email group, which can be done via our website or by emailing a request to us to be added to this list.

Travel

Edward is in Nelson 2 July, Blenheim 3 July, Auckland 5 July and Queenstown 26 July.

Kevin will be in Christchurch on 12 July.

David will be in Lower Hutt on 10 July, Palmerston North and Wanganui on 17 July and New Plymouth on 18 July.

Our future travel dates can also be found on this page of our website: https://www.chrislee.co.nz/request-an-appointment

Any person is welcome to contact our office to arrange a free meeting.

Michael Warrington

---

Market News 18 June 2018

There you are, I see a potential hedge for offsetting the discontent of the recent wet, windy, weather pattern; invest in Mercury Energy shares!

Today, as one sits inside, listening to the rain on the roof, with the heating on, they’ll read that Mercury Energy has used the incessant rain to lift revenue from $523 million (2017) to $555 million.

Silver lining?

INVESTMENT OPINION

North Korea–Very impressive.

If President Trump and Chairman Kim can display the fortitude to carry out their new mutual plan, based on a simple foundation discovered in Singapore, then come 2020 they should jointly be nominated for the Nobel peace prize.

They would unquestionably deserve the award.

Effective delivery is now the question.

All the water in all the oceans needs to pass under the bridge, twice, before we can truly believe in the new direction, but maybe Trump and Kim have seen a simple opportunity to cut through the sea of red tape that government bureaucrats have put in their way for too long?

Maybe they declared ‘James Bond isn’t real’?

Who said they ‘couldn’t’ have this meeting?

Donald Trump is a most unusual operator, and a good number of his actions are more than questionable, but his unorthodoxy has just delivered the most unexpected political meeting of the past century.

Let’s talk.

Is the ‘don’t believe it’ tone of the media the reality or are journalists caught up in their own spin?

If North Korea was offered the opportunity to widely improve the quality of life for its people and thus validate the deity desire of Chairman Kim, wouldn’t this appeal?

If the cessation of ‘war’ with South Korea and moderated movement between the two was supported, wouldn’t the Korean Peninsula become a more serious economic powerhouse?

Wouldn’t the introduction of North Korea’s population as an inexpensive labour force within global economics encourage even greater global trade? (as China, Vietnam and Bangladesh have before them).

If weapons can be removed, or reduced, and the US can begin doing business with North Korea hasn’t President Trump delivered additional value to his own economy?

Sure, Kim Jong Un will now run quickly run back to President Xi to discuss the developments and plan the next move in this game of chess, but maybe Kim has also seen merit in having the US as a friend during this period of overbearing expansion of Chinese interests around him?

At present North Korea has one friend, China, and that’s not a very strong position to be in.

I see Vladimir Putin thinks the meeting was influential because he has jumped on the bandwagon and invited Kim Jong Un to Moscow.

So far, this paragraph has nothing to do with the subject of investment for you but I don’t think there are any new decisions for you to make, certainly not immediate ones.

The markets will progressively provide you with a distilled opinion about changing investment risks, but change will be slow and can only move at the same pace as the evolving level of political trust between the US and DPRK.

The first move was undeniably impressive by President Trump and Chairman Kim.

Productivity – The world is learning fast from the likes of AirBNB about more productive use of under-utilised assets that require a lot of capital to produce.

I like the AirBNB story.

This technology and data based business has significantly increased the productivity of property assets around the world.

Whilst we are witnessing tension around property supply in NZ, our service levels to the very important tourism industry would have been intolerably low by now without the emergence of AirBNB.

I especially like that it has directed some of the tourist dollars directly to private property owners who are now well remunerated for this proportion of administration, cleaning and marketing that they do on their own property, as opposed to working for another entity at $18-22 per hour in many cases.

If you are an AirBNB property supplier, don’t fight the new taxes being discussed; embrace them because they are validation of the business model and the business you are now running.

Be sure to charge enough to cover all such costs, leaving yourself a reasonable return on the value of the asset that you are managing.

Asset sharing, or leasing, doesn’t stop with AirBNB. Actually, it didn’t start with AirBNB but it was improved use of technology for consolidation and peer-to-peer connection that has seen asset sharing explode in scale.

The cloud (offsite computer storage) has proved we do not need to maintain our own large collection of computer hard drives; specialise and share makes more sense (witness Infratil’s successful investment in the Canberra Data Centre).

Days on the snow, relative to the price of skis, proves to me that I’d be mad to own my own.

In NZ a few car sharing businesses have been trying to establish a foothold, and this makes good sense given how many people are now living within the city but do not have a permanent need for a vehicle.

Most travellers know of ‘taxi-like’ businesses like Uber (Lyft, Gett, Grab) and many of the major vehicle manufacturers are investing large sums in them.

Last week disclosed another competitive threat (or is it complimentary?) to the short-term vehicle-sharing businesses; Mercedes Benz is joining Jeep and Porsche and starting a medium-term car subscription service as an alternative to ownership.

No doubt others will follow and this should become a win: win outcome as vehicle manufacturers find ways to increase their profit per vehicle (which may well involve lower gross vehicle production) whilst consumers find they spend less annually on personal transport.

Ultimately, it’s possible that all of these vehicle hire services have a role, bumping ownership off the list as the most common way of accessing a vehicle, and that sounds like another move toward capital efficiency (and better productivity).

These vehicle manufacturers have not been put off by pressure to use bicycles and public transport, they can see clearly the public has a desire to use cars but they have seen the success of asset sharing and are jumping on the (powered) band wagon.

Electric cars are currently grabbing most of the headlines as the next wave of change, and their use will expand, but I suspect that vehicle sharing (all fuel types) will be the next major evolution within the private car use sector.

This all begs the question, what other inefficiently used assets should be considered for sharing?

Long Value – Investors in the bond issued by Summerset last year (SUM010), and perhaps those who rejected the offer believing that interest rates were rising, may recall my comments at the time that I viewed it as a race between a tortoise and a hare and that the tortoise would win.

The tortoise is the SUM010 bond paying interest at 4.78% per annum (paid quarterly).

The hare is a rolling sequence of 12-month term deposits with a bank.

Usually it’s the hare that leaps ahead from the start line, but the tortoise has the longer legs at 4.78%.

12 months into the six-year term and we now know that the hare will need an engine rebuild to catch the tortoise.

In year one, a 12-month bank term deposit paid 3.50% and this rate applies again for the second 12-month period.

Factoring in the effects of compound interest I also offer the following news that will be rather unsettling for the hare:

After earning 3.50% p.a. for two years, the hare will now need to earn 5.41% p.a. for the next four years to align its deposit-based returns with the Summerset bond (SUM010).

In my view the hare is more likely to discover the antidote for calicivirus #2 than a 5.41% for a senior ranking, four-year, fixed interest investment.

Let’s just say that the hare preferred the lower risk profile of bank deposits to the risk offered by the Summerset bond and accepted lower returns throughout.

We can do that math too.

At the time, the hare could have easily achieved a 4.25%p.a. interest rate for a five-year term deposit (so probably a very similar rate if banks offered six-year deposits).

Again, after achieving 3.50% p.a. for two periods of 12-month term depositsthe hare now needs to earn 4.61% for the remaining four years to break even.

At least 4.61% is visible, with binoculars, and ambitious hopes regarding inflation, but the hare will definitely need the teachers’ union to achieve the 16% pay rise they’ve demanded to have any hope of this higher interest rate becoming a reality within the time frame.

The point of this little game of numbers is two-fold:

To congratulate SUM010 investors on their astuteness; and

To remind fixed interest investors that they require a very robust view about rising interest rates to strategically avoid use of some long terms in their portfolio mix.

As a cross reference, the wider market opinion has caught up with my original view about value for you and now agrees to purchase SUM010 bonds with a market yield of 4.00% between now and 2021.

Investment News

Fees – Without wanting to get into the ‘value add’ or ‘value subtract’ debate, I couldn’t help but raise a cynical eyebrow as I read about the first fund manager to ‘generously’ agree to remove all performance fees from its mix….

… and replace them with a higher standard annual fee!

The regulator spoke; they do not like these variable fees that might be difficult to understand, so, fund managers’ have begun to remove them and replace them with much simpler, much bigger, static fees.

Is this a ‘be careful what you wish for’ moment for the regulator or one of total selfishness by the fund management sector?

US Fed – The US Federal Reserve lifted it official cash rate by 0.25% to sit between 1.75% - 2.00%. This part of the announcement was no surprise.

The markets were a little surprised by the increase in forecasts for how high the Fed Funds rate might reach, by late 2019.

Previously the market, and the US Fed ‘dot plot’ from governors, had speculated on 2.875% for 2019, but this target has moved to 3.125% and on to an ultimate high of 3.375% (before receding a little).

The Fed Chairman Jerome Powell described the US economy as doing ‘very well’ so now the debate is about sustainability beyond the injection of the tax cuts.

The yield movements on longer term US Treasuries (5, 10 and 30 year) will ‘talk’ to us about market confidence in these target Fed Funds rate levels becoming a reality.

Media Ownership – In the same week that our Appeal Court is being asked to question the Commerce Commission’s right to make commercial assumptions about public good, when it denied the merger proposal between Fairfax and NZME, the US District Court has approved AT&T’s takeover proposal for Time Warner.

One day after the US judgement Comcast launched its own takeover for 21st Century Fox.

Sky TV still has a lot to prove to its shareholders about its financial potential, but these takeover wars make it clear that distributers of content still hold relatively robust commercial opportunities in our society.

Rather than forcing a $100 million+ (estimated in court) inefficiency upon Fairfax and NZME our Commerce Commission might have been more effective if they simply ask our politicians to approve the $30 odd million to NZ public radio to ensure they could provide a perpetual scroll of news across radio, and internet based video and written content (remember the Minister Curran and Carol Hirshfeld saga).

Turkey – President Erdogan has called an election for this weekend, after conveniently imprisoning one of his strongest critics arrested, SelahattinDemirtas of the pro-Kurdish HDP party.

Erdogan seems to have the majority of public support, but it is troubling that he wishes to convert this opportunity into an authoritarian state with unpleasant political undertones.

Where once Europe had courted Turkey to become a member of the EU, and to be Westward looking,Turkey is now reverting to their ancient role as a ‘energised’ gateway between Europe and the Middle East.

Chicken –Tegel Chicken shareholders are now positioned to consider their decision regarding the takeover offer.

The directors recommend acceptance.

The dividend will be received by TGH shareholders regardless of their decision. (TGH goes ex dividend on 28 June).

The Overseas Investment Office approval (or not) is the main condition to be satisfied, with some risk to also meeting any revenue target conditions.

Bounty already has 65% of acceptances, so their condition of achieving control has already been met.

There is no rush to respond; investors have a free option to hold onto their decision until August and free options are always worth having.

Ever The Optimist – NZ company ‘Upside Biotechnologies’ (born out of Auckland University) is 80% of the way along a journey toward growing largepieces of skin for burns victims, starting the process with skin cells from the victim.

They are off to the US for final testing within a population that offers sufficient scale.

ETO II – NZ primary industry exports grew 12% last year to $42.6 billion, $1 billion better than forecast.

This is one of our most important economic engines and we must work to a strategy of ‘constant virtuous improvement in productivity’.

ETO III - Avocado growers are getting the rewards they deserve having invested in the trees but then must wait years for saleable produce!

Avocados have hit a seasonal high price at $5.05 and should yet reach higher with July and August the typical high points.

If you are an avocado lover, as I am, then you may question this being a point of optimism, but successful production precedessuccessful consumption.

Investment Opportunities

Meridian Energy – the new 7-year senior bond offer was arranged on Friday, and the interest rate was set at 4.21% p.a.

Those with a firm allocation from us should have received a contract note from us.

Thank you to those who participated in this bond offer through Chris Lee & Partners.

If you missed the issue, but still wish to invest please contact us and we can arrange a purchase on the secondary market for you.

China Construction Bank – issued its $90 million of new 5-year bonds at 4.01% p.a. last Thursday.

Thank you to all who participated in this bond offer with Chris Lee & Partners Ltd.

Genesis Energy – has announced its new subordinated Capital Bond offer of up to $240 million (code GNE050) to replace its old version of the same bond (GPLFA).

The offer document is available on the Current Investments page of our website, expanding on the terms of this 30-year bond, with possible reform after 5 years.

Whilst I think aspects of the offer are awkward (Priority Pool and General Pool) GNE has helpfully offered the ability to use old GPLFA bonds to pay for applications into new GNE050.

GNE has set the interest rate at a challenging level (minimum 4.65%).

Kevin Gloag is writing a research piece for this bond offer. Clients receiving a financial advice service from us will be able to access this research on the login page of our website later tomorrow.

We have a list for investors wishing to consider the new GNE050 subordinated bond offer.All investors are welcome to access bond allocations through a firm process with us.

The fastest way to hear about new investment offers is to join our ‘Investment Opportunities’ (New Issues) email group, which can be done via our website or by emailing a request to us to be added to this list.

Travel

Edward is in Nelson 2 July, Blenheim 3 July, Auckland 5 July and Queenstown 26 July.

Kevin will be in Christchurch on 12 July.

David will be in Lower Hutt on 10 July, Palmerston North and Wanganui on 17 July and New Plymouth on 18 July.

Our future travel dates can also be found on this page of our website: https://www.chrislee.co.nz/request-an-appointment

Any person is welcome to contact our office to arrange a free meeting.

Michael Warrington

---

Market News 11 June 2018

Latin was long gone from college by the time I arrived, although it was quoted often in our home.

I still like the simplicity of some phrases, which are more succinct when in the base language of Latin.

The one I stumbled upon last week, and felt immediate alignment with, was:

‘Esse quam videri’

The English translation doubled the word-count – ‘To be, rather than to seem’ and I often convert it to five – ‘show me, don’t tell me’.

The internet is a marvelous and productive development for the world, but it has also allowed for a massive increase in ‘talk’ relative to ‘action’. (says he writing the newsletter – Ed).

INVESTMENT OPINION

Patience – I have been with Chris Lee and Partners for 10 years now, which presents me with a little time-passing anxiety; my eldest son has started and finished both college and university, the photo on my desk of my youngest son (now 16) is of a 6-year old with 20 multi-coloured rubber bands tying up his hair.

Shortly after joining CLP I reached the age defined as the answer to the ‘the life, the universe and everything’ (42 for non-fans).

Yet, in my case I still had much to learn, or perhaps earn (school fees etc), because I am still here as I approach 52.

10 years.

I should probably say it quietly to reduce the impact.

Those of you (investors) who’ve known me for all of those years and would frequently tell me how frightfully long term a 5-year bond is might reflect on the difference, and just how ‘quickly’ 5 years passes.

I too have been reflecting on the 10 years, considering the value added by a financial advisor, and CLP in particular, and I have been pleased to be able to underscore several points of marginal value throughout the past decade.

The year I arrived, 2008, the failure of the finance company sector and then the arrival of the truly disturbing Global Financial Crisis meant that our greatest value was to help the investing public to understand what was happening and the importance of reacting actively.

The primary, and appropriate, reaction in 2008 was a protective behaviour, but since that point most of my reviewing was about the options we advised for adding value, of which I can recall three major tidal threads:

Longer duration; then

Subordinated bonds; followed by

Increased use of shares/property exposures.

Now I am contemplating what the next successful investment behaviour might be for the five-year period ahead?

Longer duration – since 2008 we have been urging investors to invest for longer terms. Initially (2008-2012) this was to protect against the obvious decline in nominal interest rates as the GFC was responded to and the central bankers grappled with what influences were continuously suppressing inflation.

Yields on strong senior bonds and bank deposits were 8.00% in 2008 (pre GFC) and they remained well above 5.00% for several years. Hanging on to this long-term fixed interest investment theory protected people’s income for long subsequent periods, which are only now slowly coming to an end as they are repaid.

The slump in short term interest rates, which remains to this day, means that investing longer term still offers a better run rate, albeit with a much smaller marginal benefit now.

That smaller benefit means ‘we’ have more time to consider other options before committing to longer term investment.

The second winning tidal movement that we encouraged was participation in subordinated bonds (second ranking fixed interest investments) predominantly offered by very robust entities, such as the banks and utility companies.

At the time when underlying interest rates were slumping to their new lows of 5.00% (and lower) various entities were issuing subordinated bonds to boost the synthesised equity recognition on their balance sheets for regulators and credit rating agencies.

Internally we questioned the merit of ‘synthetic’ equity to a business, but if the rules allowed robust borrowers to pay higher returns to our clients in return for this alchemy we were happy to participate.

At the time, the credit margins (additional return for additional risk) for subordinated bonds were a mix of cheap or appropriate with interest rates often falling within the range of 8.00% - 9.00% and this was attractive to all investors, but especially fixed interest investors.

With the benefit of hindsight 2009-2012 were excellent years to increase one’s exposure to shares but this move didn’t come naturally to most investors, especially those around retirement age who hold the majority of the savings pool.

I asked my Kiwisaver provider at the time (2009), ‘which direction of risk are members moving toward?’; the answer was unambiguous ‘toward lower risk’.

There was a lot of debate about the misunderstood risks of subordinated bonds during the period of heavy issuance.

With respect to the bank issued subordinated bonds we specifically spent a lot of time, and used many words, to inform investors and thus remove the misunderstandings so people could more accurately recognise the attractive rewards that were being presented for the relatively low default risk on offer.

The risk of default in the banking sector was low in Australia and NZ and with each passing regulation the sector was becoming stronger.

I often thought that the early generation subordinated bonds were simply optical illusions designed to satisfy regulators and credit rating agencies, which they did, with only negligible risk of failure reaching investors.

Arguably the tax base had more to be concerned about given the higher level of tax deductibility from the higher interest costs paid by banks on subordinated bonds.

The regulators would argue, logically, that if a bank failed then subordinated bondholders would have their money converted into the ordinary shares (real equity) of the entity to try and ensure its survival and lose large proportions of their investment value.

This was all true in theory but was highly unlikely to occur in practice.

Central banks recognised this disconnect as they evolved what terms and conditions would be acceptable for equity recognition from subordinated securities (bank issued) from that first generation through to the latest iteration of rules from the Reserve Bank of NZ, who would almost prefer to do away with bonds masquerading as equity altogether.

Subordinated bonds with their very attractive credit margins, typically an additional 3-4%, proved to be very attractive risk adjusted rewards for investors between 2011 and 2016 and we are pleased that our clients participated.

As the regulations have evolved investors can see that banks are progressively redeeming the old series of subordinated bonds. Rabobank and ASB are the only banks with old subordinated securities on issue in NZ and Rabobank’s RCSHA will be redeemed in 2019 (my view) leaving only ASB to face its moral integrity issue with repayment.

If ASB does not repay its old securities (ASBPA and ASBPB), and thus takes unreasonable advantage of investors, it is our view that investors should never support a new subordinated bond series from them, or CBA, until they are repaid.

By 2020 we expect all first, and second, generation subordinated bank bonds to have been redeemed.

This led to the third wave of value successfully pursued by investors, increased portfolio weightings to property and company shares.

Depending on one’s start point the scale of benefits from increased investment in property and company shares has ranged between good, and very good.

As it happens investors didn’t need to act prior to 2012 to gain value from the share market, because bond returns were increasing in value at a similar rate,so the more circumspect had opportunity to participate in shares. Prior to 2012 bond indices performed at a similar rate to share indices, so very few investors were left behind; it was only after 2012 that the share indices accelerated, and value change outperformed fixed interest investment.

Share market pricing has been repetitively strong for an unusually long period of time (6 years at the current gradient of price change).

Initially the uplift began with price recovery post the GFC distress, prices continued to rise as uncertain business profit forecasts were confirmed and, in many cases, profits increased and then finally premium pricing was paid for shares when investors recognised that the opportunity cost of zero interest rates was affordable for all participants (businesses and investors) to accept greater levels of risk.

I think it is worth re-reading that last italicised sentence again.

The interest rate strategy is no longer zero. Yet the majority of investors and businesses still hold greater levels of risk.

I often tell people that the share markets are priced for upper quartile performance expectations; the truth is that it’s probably pricing upper decile.

Regular readers of our newsletters will know that we expect to have a positively shaped yield curve for many years (short term interest rates below long-term interest rates). In NZ the potential for this outcome is aided by the success of our macro prudential tools used by the Reserve Bank.

Very low short-term interest rates make it harder to have high long-term interest rates because the finance sector profits from ‘borrowing short term, to lend long term’.

So, the prospects of an Official Cash Rate at 1.75%, up to maybe 2.25%, leaves me believing that interest rate returns will be unlikely to exceed profit-based dividend returns over long periods. (See next week’s Market News for an example of this math).

This statement sounds very logical, but it hasn’t been typical of the situation throughout my career as inflation fell at the slope of black diamond ski run whilst bond returns slowly stepped lower with a profile more like the steps of parliament.

The area between these two lines left a lot of real yield value on the table for investors.

That situation has changed.

In my opinion there is no free, or easy, hit with interest rates now. Inflation is stable, not declining, and real yields have been compressed. The Official Cash Rate in NZ has a negative real yield.

Profit based dividends, for the most part, sit above interest rates, as they should to reflect the additional risk of an equity investment. Businesses not paying out meaningful dividends must convince shareholders that the capital is better used within the business for immediate growth potential (retirement sector, Synlait Milk etc).

A highly priced share market will not be easy to exit from, if you concur with our view about low nominal and real interest rates, albeit that micro changes to specific holdings often need to occur.

However, as preached, a good investment policy will help with your decision making.

Please maintain a good set of investment rules for managing your portfolio and interact with us for specific financial advice. Keeping your own portfolio in good order can happen without the need for speculation about future pricing of investments.

I started this paragraph (thesis! – Ed) with the label ‘Patience’.

I did so on the basis that I was contemplating the next valuable tidal movement during the five years ahead for investors, remembering that five years is not a long period for investing.

If interest rates remain low, and share pricing remains high, what is the next winning strategy?

I think the answer is patience.

Wait for the market to present you with value. Extract a fair price for the activation of your capital.

Yes, this probably means accumulating more cash than you are familiar with (those with NPF accounts win on this score) and holding it for longer periods than you’d prefer but think of it as spending a little of the ‘parliament steps’win from the past to finance the careful search for the next item of investment value.

Patience does not mean ‘Mike will call us on a specific date’. We’d ask that clients receiving a financial advice service from us continue to reach out to us when they hold high cash balances and have questions about opportunities.

Each new investment opportunity will emerge in its own good time.

Six weeks ago, the market decided to push Vector’s (VCT) share price down to $3.15 yet a week later the directors declared a higher dividend and an intention to increase it +0.25 cents per share each year.

For indexation reasons the price of Mercury Energy (MCY) shares retreated to $3.10 from $3.40 but MCY had sufficient surplus cash reserves to buyback some of its own shares and buy 19.9% of Tilt Renewables (TLT).

These scenarios happen often enough for the patient to benefit.

If I’m correct about a new stability for market performance, let alone a retreat, then the real cost of high annual fees will begin to show up more in future than they have in the past (1% deducted from 10% doesn’t feel bad, but 1% deducted from 5% will be an avoidable frustration).

So, I think we have entered the fourth era of my time here, one where value will be extracted through patience. (not your strong suit – Ed)

Investment News

CBA AML– Last year I discussed the astonishing failure by CBA bank relating to their Anti Money Laundering obligations.

I recall thinking, and thus probably saying to you, that CBA is about to experience the largest AML fine ever.

The fine has now been ‘agreed’ at AUD$700 million.

I didn’t place an exclamation mark after the amount because it didn’t move me, even though it is 15x larger than the previous high for a civil fine. I pondered whether a fine of AUD$1 billion was possible, and this was probably the starting point from the regulators negotiating team.

The CBA negotiating team will have presented shocked faces during every stage of the penalty negotiations, presumably laying negotiating platform for shock by offering to pay a fine in the tens of millions.

By mid-year CBA disclosed acceptance of AUD$375 million as a possible fine.

CBA shareholders clearly shared my view about the fine, pushing the share price up following the announcement.

CBA’s behaviour was very poor, but readers should take notice of the seriousness that regulators place on us all meeting AML obligations without exception.

There’ll be a few unhappy technology sales people too, after this story is digested. CBA describes its ATM’s as ‘intelligent’, but that intelligence was clearly more ‘artificial’ than the technology team disclosed to management. (garbage in, garbage out – Ed)

Ever The Optimist– New Zealander Tim Brown’s ALLBIRDS shoe brand has clearly hit the echelons of the highly paid and popular in the US.

This quote comes from global media and economics giant Bloomberg:

‘Put yourself in the shoes of the top leadership at Google parent company Alphabet Inc. (Those shoes are Allbirds)’

Investment Opportunities

NZX Bond – This bond offer is complete.

Thank you to all who participated in the offer through Chris Lee & Partners.

Meridian Energy – has announced a new 7-year senior bond offer.

The bonds will have an estimated yield of 4.25% (to be set on18 June).

This will be a fast-moving offer, booked by contract note, with investors paying the brokerage cost.

Genesis Energy – has announced a new subordinated Capital Bond offer of up to $240 million (guess code as GPLFB) to replace its old version of the same bond (GPLFA).

We are yet to see the Product Disclosure Statement, but the new bond will have a legal term of 30 years, and a shorter term as the likely lifecycle and will require an interest rate exceeding 5.00% to be competitive.

Genesis is holding an inappropriately small priority pool ($40 million) for the holders of the $200 million GPLFA bonds to consider reinvestment, so those wishing to reinvest via the priority pool will need to act smartly, once they receive documents form the registry.

All investors are welcome to access bond allocations through a firm process with us.

If the new GPLFB bond issue process is successful, all GPLFA bonds will be repaid on 15 July 2018.

We have started a list for investors wishing to consider the new GPLFB subordinated bond offer.

Travel

Edward is in Taupo 13 June, Nelson 2 July, Blenheim 3 July, Auckland 5 July and Queenstown 26 July.

David will be in Lower Hutt on 10 July, Palmerston North and Wanganui on 17 July and New Plymouth on 18 July.

Our future travel dates can also be found on this page of our website: https://www.chrislee.co.nz/request-an-appointment

Any person is welcome to contact our office to arrange a free meeting.

Michael Warrington

---

Market News 4 June 2018

For those of you who like true stories from this often bizarre ecosystem that we call financial markets I have been reading a very interesting book about a financial markets investor previously based in Russia.

It became clear that I needed to read this book after three separate clients recommended it to me.

The book’s title is Red Notice; an autobiography by Bill Browder, and whilst some familiarity means little of the book’s investment content shocks me its content will likely shock most of you. It’s corruption content should be a shock to all.

In my past life I arranged transactions involving a client with vast exposures to Russian financial markets. This particular client’s fortunes came to an abrupt end in 1998, beginning with tension between Russian politicians and the country’s greedy oligarchs, which is spelt out in the book.

Another Kiwi who I had worked with was also working in Russia at the time, very successfully, and he was so close to this developing Russian situation that his firm was named in the book!

So, if you are interested in content that reads like a combination of James Bond and financial markets, this book is for you.

Investment Opinion

Tiwai Point– An alternative view reached me about the government subsidy, from a smelter manager no less, via a New Zealander enjoying the Bluff Oyster festival.

The government contribution helped smooth out the trough and now Tiwai Point smelter is benefitting from President Trump’s trade games that impact negatively on other smelters in the likes of China and Russia.

The opening of the fourth pot provides greater comfort for employees, who I genuinely hope are being better paid as a result of increased business demand and their government’s support for the private employer.

Another message was that it was good to see the government taking a long-term view when so many companies adopt very short term, reactionary behaviours.

It’s always good to consider other perspectives and even better to receive them.

Italy – Let them sweat.

I’ll bet these words are being spoken behind closed doors at the European Central Bank (ECB) with respect to Italy’s developing financial stress.

The world seems to be well into a tidal shift against excessive risk takers who have failed to correct their undesirable financial course post the global financial crisis (GFC), specifically those with too much debt.

Good financial principles have been knocked over by the drug of 0.00% cost of funds, or opportunity costs.

The price of the drug (opportunity cost) is changing.

It always seemed to me that those countries, or companies, with excessive debt would become the target for serious financial market stress testing and to my eye it looks as though more stress testing is underway.

I don’t mean a stress test arranged by a government department or central bank auditor with a preferred conclusion of ‘it will be fine’; in this case the borderless and undemocratic global financial markets are delivering the stress test.

As you witnessed recently with the collapse in the value of the Turkish Lira, financial markets have no political agenda and no sympathy for those being compressed under the weight of financial pressure.

Not even corrupt leaders can influence global financial markets when the opinions of major financial decision makers synchronise.

The flag bearer for last week’s discussions in the media about financial distress was Italy, a country which has spent months trying to form a new government yet the financial market response has been a conclusion of incompetence and to begin driving the interest rates on their government bonds skyward.

Higher risk deserves a higher return.

For most of the past nine years, post the middle of the GFC, central banks slashed interest rates to around 0.00% and like a school yard bully the central bankers declared they would take on all-comers and buy all bonds that investors did not want, thus reinforcing the guarantee of access to finance.

‘0.00% cost, for unlimited funding, come and get it’.

What could possibly go wrong?

You didn’t need Charles Darwin and David Attenborough to tell you the situation was unnatural, but they may have been willing to make predictions for you; survival of the fittest will prevail.

Last week Italy’s 2-year government bond moved from 0.25% up to 2.74% (by Tuesday night). It’s 10-year bond moved from 2.39% to 3.17%.

These moves are enormous for a developed nation, albeit that they are showing a lack of development at a political level.

Rates declined in the following days, but the damage has been done, the Italian market is exposed.

Here are a few other relevant countries government bond yields for the same terms (2 and 10 year):

Germany: -0.76% and 0.30%

Spain: -0.01% and 1.58%

Portugal: 0.23% and 2.24%

US: 2.43% and 2.87%

New Zealand: 1.89% and 2.76%

It is a little difficult to make simple comparisons with countries outside the European Union (US and NZ) but inside the union is much easier.

German interest rates are the mirror image of Italy, and are falling fast, as investors move to the safe haven.

Some money has moved to the US and NZ will not lose relative position because of our robust financial position and governance.

Portugal and Spain once offered higher yields than Italy but are now lower having taken action to improve their financial situation and gaining capital market confidence and central bank respect as a result.

It took a little too long, but Spain and Portugal are examples of movement in the right direction, financially speaking, and they are now enjoying the fruits of support and low cost of debt to continue their journey.

Italy by contrast has stretched the relationship too far and believed the ECB promises of ‘whatever it takes’ support too literally.

If the ECB is the metaphorical parent (guardian, supporter) then it has temporarily changed the locks to the front door for the Italian child and left them out in the cold for a while.

Financial markets have just realised this and begun to panic about lost value on Italian government bonds.

Foreign investors own 27% of Italian sovereign debt, the ECB owns 20% and the balance is owned by Italian institutions, predominantly their banks.

Default on Italian government bonds isn’t a credible thought, but yield movement up to align with the likes of Greece (4.50%) is credible and on a 10 year bond this movement results in a painful revaluation loss.

The pain gets worse if you are forcibly extended on your Italian bond maturity (‘agree’ to switch 10 year bonds for 40 year bonds) and to accept intolerably low returns if you wish those bonds to be accepted as collateral by the ECB.

A while later the ECB might agree to provide some emergency funding to Italy, but not until interest rates lift to much higher yields (Let them sweat).

Even when using public money higher risk deserves higher reward.

Investing in European government bonds was never price-risk free and it never should be. Even if default is an intolerable concept for the European Union (capital guarantee), at this juncture, loss of value must always be a possible outcome.

Default may not have occurred but technically forcing a bondholder from a 10-year bond, at say 3.00% interest rate, into a replacement 40-year bond at say 1.00% can quickly burn up 100 cents in the dollar of value.

Credit margins (additional interest return for higher marginal risk) have been increasing during 2018, especially for the weakest borrowers so the stress test is also occurring within the corporate debt markets.

The moves for corporate credit margins haven’t been as violent as experienced by Italian government bonds, but the message is the same; those with too much debt will be hurt in this environment.

Do not underestimate the importance of the Italian yield moves. They, and any other similar moves, will have an impact on the price of borrowing money in NZ.

OBR – The Open Bank Resolution law was put in place when regulators acknowledged there would be an urgent need to ensure banking services were available to our economy even following an event of financial failure by one of our banks.

OBR contemplates having a failed bank re-opened within 72 hours.

The Reserve Bank must have been more than a little unhappy when they witnessed a three-hour outage for the BNZ due to a simple power supply problem in…. Australia!

The central bank had previously sought to separate financial risk between NZ subsidiaries and their parents, and have done so, but this operational failure discloses that technology for NZ banking is dependent on the Australian parents, and their power supply.

What else is NZ banking dependent on Australian offices for?

BNZ front line staff will be as frustrated as the Reserve Bank because they received the client criticism, without any chance to have influenced the failure.

I cannot fathom why a bank as large as National Australia Bank didn’t have an Uninterrupted Power Supply (UPS) in its network. We have one.

Consumers have been reminded again of the value of diversity; one payment method is not enough, and electronic payment methods are exposed to the performance of… electricity supply and computer performance.

What happens if a bank fails, cannot pay its bills, and before the central bank steps in the power company cuts off supply in response?

M-Bovis – Hope for the best but prepare for the worst.

The government has boldly decided to have a go at removing Mycoplasma Bovis from the NZ dairy sector.

Bold is good, even if confidence of success is 50:50 at best.

I’d take those odds with a scenario like this, so I am hoping the odds of success are that good.

However, I’ve heard from well informed people that the odds of success are much lower than that, which leads to the point of this paragraph; as an investor you should factor in a greater than 50% chance that eradicating M-bovis from NZ will fail.

This low confidence seems fair given the report that ‘High-risk animal movements have been traced to 3000 farms. About 300 properties are in biosecurity lockdown and 858 are under surveillance’.

I wish the government had been able to avoid quoting dollar costs from the strategy because I expect costs to be far higher than quoted.

Politicians always make the error of quoting lower quartile cost estimates and upper quartile confidence declarations when the opposite is infinitely wiser.

If I was a politician, the Primary Industry minister in particular, I would set a non-negotiable objective of a water-tight stock register, a database for stock details and stock movement plus regulations making reporting compulsory.

If the data from this exercise, and a future tracking competency, aren’t used to protect us from the next disease, that would be the disgrace from M-bovis, not the attempt to eradicate.

Nick Tuffley from ASB put a sense of scale on the loss as being like a drought, so it will have a suppressing influence on a large scale and on the productive part of NZ’s GDP.

He logically offers that the reduced milk supply should result in slightly higher milk pricing, with an additional 30 cents per KgMS being equivalent to current stock loss estimates, albeit that losses aren’t being shared equally across all farmers.

Shane Jones probably feels like his $1 billion regional growth fund has just been netted to zero by the reduction in spending that is likely to occur from the wide-spread dairying businesses.

The Reserve Bank statistics display dairy sector debt ratios as one of its closely monitored concerns (a ‘key vulnerability’) so they will be on heightened alert now from a financial stability perspective. Italy’s massive disruption, touched on above, is another of the ‘key vulnerabilities’ (international financial risks) given our dependency on offshore funding.

Meatloaf once sang that ‘two outta three ain’t bad’ but I am certain the Reserve Bank would sing it differently.

Next year’s forecast $7.00 KgMS milk price will provide bankers with some cash flow comfort, but the looming threat of huge reductions in the capital stock is an unavoidable concern.

Meanwhile for investors more widely, these themes hover in front of me:

Fonterra’s inability to incrementally add more value to processed products regardless of the underlying milk price. A further lift in the milk price, alongside a fall in supply, doesn’t bode well for profits to Fonterra’s owners;

Any fall in economic confidence will contribute to RBNZ decisions to hold short term interest rates at their current low levels;

The majority of us are genetically pre-disposed to hope for the best, but in this case, I think investors should prepare for the worst outcome.

If the best happens it will be celebrated more widely than a personal portfolio.

Investment News

No News? – There is always plenty of news, but on this occasion, I have already used up plenty of words above!

If you have questions about specific pieces of news you are always welcome to ask for our view.

Actually – There is one news item, Mercury Energy fessed up well to an embarrassing error of unnecessarily disclosing personal data (email ,CSN) in a file they delivered to the Companies Office.

Their disclosure of this error was made on the very week that the European Union launched its new General Data Protection Regulation (GDPR).

This will be the reason you have been receiving many other emails updating you on privacy policies (without their behaviours necessarily changing – Ed).

Mercury missed one useful piece of advice that your MCY shares remain safe;

Any person trying to sell shares needs a broking account. You cannot set up a broking account without completing the necessary Anti Money Laundering obligations. If the shareholder name and the trader standing in front us don’t match, no sale will occur.

Ever The Optimist– There’s always someone happy about the cold snap (skiers like you – Ed).

Yes, but this one is productive; the Kiwifruit industry is very grateful for the timing of a sharp drop in temperature as it helps increase the final sugar content and shut down the vines for harvest.

More good news for a well performing industry.

Investment Opportunities

NZX Bond – The new subordinated bond is open. (closing 15 June)

If you have a firm allocation from us, please act now to complete your application form and deliver it to our offices prior to 11 June.

The 5.40% interest rate accrues from the time of processing so there is value in acting early.

If you are also an NZX shareholder, you should also consider submitting an application into the Priority Pool for more bonds (closes on Friday).

Summerset Group – indicated in a recent corporate release that it is considering issuing a new bond (SUM020).

Given the new methods available to the market under FMCA law, it would be remarkable if their new bond weren’t identical to its current bond (SUM010) except for the maturity date and interest rate.

One can certainly get a head start on considering all the key risks of lending to SUM.

Housing NZ – has received permission to increase its funding programme via bond offers.

HNZ intends to offer a 5-year and a 7-year bond later this week.

HNZ’s very strong credit rating implies relatively low interest rates (between 3.25% - 3.75% as an estimate).

We will keep you updated here.

Fletcher Notes – We continue to keep our FBI170 list open for those wishing to hear more about the possible supply of this fixed interest investment.

All investors are welcome to contact us to join lists if they wish to invest under a new offer.

The fastest way to hear about new investment offers is to join our ‘Investment Opportunities’ (New Issues) email group, which can be done via our website or by emailing a request to us to be added to this list.

Travel

Edward is in Taupo 13 June.

Chris is in Auckland 18 June, Whangarei 19 June, Auckland 20 June and Christchurch 26-27 June.

Kevin will be in Queenstown on 15 June. (with an extra layer of clothing for the early snow!)

Our future travel dates can also be found on this page of our website: https://www.chrislee.co.nz/request-an-appointment

Any person is welcome to contact our office to arrange a free meeting.

Michael Warrington

---