Market News 29 October 2018

OK, I hear you, it’s time that someone took this emerging market research seriously.

I’ll pack my note pad and see what I can learn about the Argentinian situation for you.

I’ll be back in a while.

INVESTMENT OPINION

Italy – The situation for Italy seems to be slowly getting worse and like most politicians Italy’s are showing signs of puffing up their chests and egos to do battle with the European Union with a false sense of credibility as their foundation.

The credit rating agencies have begun the next period of downgrades.

Keep an eye on the market yield of the 10-year government bonds, the proxy for the cost of future debt to the nation.

Four years ago, participants in global markets accepted that the European Central Bank (ECB) would step in to help all European Nations with funding.

Italy’s 10-year government bond yield fell from 4.00% to 1.20%, closely aligned with their stronger neighbours as investors viewed default risk as negligible.

Today though, after the recent Italian election (bunfight – Ed) and the budgeted deficit with its two-finger salute to the EU, Italy’s 10-year government bond yield has lifted to 3.57% and is on an uncomfortable path higher.

Rising market yields reduce the present value of bonds.

Banks, insurance companies and fund managers are the largest holders of bonds, which lose value for them if interest rates rise.

Fund managers will report the poor performance to their investors and move on, but for banks and insurance companies it ‘removes’ equity from the balance sheet, which draws the attention of regulators (central banks) who remind them of the need to maintain minimum proportions of equity in relation to their assets.

This conversation would have been on ‘rinse and repeat’ as Italian bond yields rose up through 2.00%, then 2.50%, then 3.00% and now we are at 3.50%.

To put this in perspective, the move from a 1.25% market yield to 3.50% yield reduces today’s value of a 10-year bond by about 19% (a 10-year bond value would decline from $10,000 to $8,100).

Banks usually hold some equity against loans and bonds; let’s generalise by saying equity is about 10%, so for every $10,000 bond they hold they are required to have $1,000 equity (plus $9,000 borrowed from depositors). Sometimes banks get permission to hold less or no equity against government bonds due to their extremely low default risk (unless it is Italian? – Ed).

Even if Italian banks did not need to hold equity against a $10,000 government bond, they still need to find $1,900 now to neutralise the capital value lost.

If their current equity settings are low, or misleading and deceptive as some stories would have us believe, those banks must be rapidly approaching a requirement to contact their shareholders and ask for more money (issue more shares).

The market is aware of this concern because the share prices for Italian banks are falling. Using an ETF to provide you with an average (FTSE Italia Banche) the bank share prices have fallen 32% since May 2018.

It’s not a great time to raise new equity when investors dislike you or your prospects.

What if the Italian bond yields rise even further, as they do when investors believe that the borrower has become a greater risk of non-repayment?

US Dividend – When will the US government receive a financial dividend from its decade of loose monetary and fiscal policies?

By financial dividend I mean a lift in tax income to the point of fiscal surplus and thereafter the potential for reducing the nation’s nominal debt levels.

The US economy, employment, business profits and asset values are all demonstrably better now yet large fiscal deficits continue and debt levels have become huge.

The US hasn’t enjoyed a fiscal surplus since the Bill Clinton presidency (1993-2001).

New Zealanders’ are becoming familiar with the swings from fiscal surplus to deficit, and back to surplus, across the periods of economic success (now) and stress (2008-2011) so NZ is in a reasonable position to be concerned if other nations fail to ever put their heads back above water.

At least we should be, although our population’s private debt levels are unacceptable and thus at an individual level our debt behaviours are more aligned with the US (rising debt levels during periods of rising income when the opposite should be the case).

The US is self sufficient in energy and food resources, so their financial position isn’t of great note short term, but it seems wise to have a strategy for making one’s finances robust also and doing so through the collection of sufficient taxes during strong economic times.

Debt Kills – Too much debt will always kill you.

US mega retailer Sears, Roebuck & Co has a 125-year history, but its recent path of failing to adapt, declining sales and rising debt use to survive all became ‘too much’ and rising debt levels ultimately became the poison.

ETF’s might be good – We have commented about the potential for Exchange Traded Funds to become tangled up in forced buying and selling activity as financial market volatility increases.

We have pondered the potential for a less-than-virtuous spiral of being forced to sell as a market price declines, then being forced to sell more if investors instruct withdrawal, then being forced to sell even more as the market price declines further.

The enormous increase in the scale of ETF’s, following massive increases in funds under management over the past 10 years, may have meant that these funds would contribute to additional volatility on the basis that their scale has migrated from being insignificant relative to market size, to now being very significant.

However, we will only know if these theoretical prophecies are validated after a period of serious disruption for market prices.

The share market declines in February and early October were clearly not disruptive enough because there was no acceleration, or extension, of market price moves during either of those episodes despite the current scale of ETF investing.

There may, in fact, be another example where evidence has proved ETF’s might be a saviour to market liquidity and thus price stability; on this occasion within the US Junk Bond market.

Where a market has poor or no liquidity it experiences huge price swings as traders and investors cross enormous price spreads fuelled by emotional opinions about the risk they face. Markets charge a price for liquidity and the price for immediacy rises if there is a lack of competition.

Tradeable ETF’s appear to be adding a new strand of liquidity to markets.

The junk bond market had become very popular recently (past 2-3 years) as investors purchased distressed bonds from companies that were beginning to get back on their feet or follow an orderly wind up to release value. 

The objective was to try and convert a heavily discounted purchase price, such as $0.20 per $1.00 of bonds, into an exit at far higher value, say $0.40 or higher.

In times of rising confidence this strategy was working well, which attracted ever more investors into the sector.

ETF managers responded to the demand and provided new junk bond funds for investors to ensure access to the wider investor population (an important point for this liquidity thesis).

This year confidence in the junk bond market waned and thus prices began to fall quite sharply (yields on the bonds rose quickly from below 5.00% to nearer 7.00%).

Based on ‘prophecy one’, that ETF investors would sell urgently and declining market prices would enforce additional selling and a nasty spiral, one could be forgiven for expecting massive value loss for junk bond ETFs and a traumatic outcome for the junk bond market, but that’s not what happened.

In response to very large withdrawals from junk bond funds over preceding days the iShares iBoxx High Yield Corporate Bond ETF (ticker HYG) experienced a surge in turnover (more than doubled the average), which clearly requires buyers and sellers to be active.

Previously traders had been concerned that ETF funds would subtract liquidity from a market place but the experience is the opposite. The HYG fund was bringing in more investors who are willing to participate in the risk type via this diverse method where they had not been willing to invest in specific high yield bonds.

The HYG fund became the most active price maker for buying and selling junk bond risk in the market place, proving to be far more effective than specific traders trying to buy and sell selective bonds.

By using ETFs to widen the breadth of investor participation market depth appears to have enhanced the market by increasing its liquidity, ensuring that trading (risk exchange) could occur well during a period of duress for pricing.

Greenwich Associates (from a UK Financial Times article) reported that demand for investing in ETF’s continues to grow, including into bond funds in higher risk emerging markets.

They explain that institutional investor use of ETFs is rising both in the number of investors and the scale of the investments being placed into tradeable ETFs.

That being the case, market liquidity may well expand further alongside this increased use of ETFs and, as noted above, better liquidity is good for efficient market pricing, which in turn is good in times of duress. 

The US Market is enormous and would have had plenty of buyers and sellers even without the presence of ETFs but tradeable ETFs appear to have enhanced market liquidity, not harmed it, and the ETF investors were not devastated financially.

Perhaps this might mean that the smaller a market is (think NZ) the more beneficial it could be to expand its use of Exchange Traded Funds?

I’ll bet NZX critics Elevation Capital would choke on such an opinion.

After our internal debate on this subject Kevin Gloag asked: ‘Has Donald Trump made ETF’s great again?’

INVESTMENT NEWS

Service Improvements – Access to information about company performance and reporting continues to improve, including the rise of online attendance for Annual Meetings.

Here’s a link to one such portal https://www.virtualmeeting.co.nz/ provided by registrar Link Market Service.

Take a look, and maybe try out attendance for a company that you are a shareholder of.

I ‘attended’ the Port of Tauranga Annual Meeting on 17 October and was impressed with the effectiveness. I look forward to the future for this medium and the potential for companies to do even more by attaching impressive video content made prior to the meetings.

An obvious downside was no cup of tea or cheese scone for me.

The POT Chairman reported that 120 shareholders participated in the meeting through the online service.

If you combine this new service with the improved disclosure on company websites, the NZX reporting, the independent participation with independent review by the NZ Shareholders Association and input from your own licensed financial advisor, retail investors have never been so well served in their pursuit of self-managed investment.

If I may, I’ll propose that a logical sequence for retail investors to follow would be:

Consider public performance data and commentary from investee companies;

Receive financial advice about an investment within your portfolio;

Submit ‘Open’ or ‘Proxy discretion’ proxy votes to the NZ Shareholders Association to attend meetings on your behalf (providing leverage); and

Jump online to view the Annual Meeting from the comfort of your home (with your own cup of tea – Ed).

There is no reason to feel disconnected from the process of assessing your investment and expressing your opinion, when sought.

POT – During my attendance of the Port of Tauranga Annual Meeting I learned a couple of new pieces of information:

It is economically ‘warming’ to learn about the ongoing growth in activity across the port;

It was a little frustrating to hear that the greatest threat to the business at present is the government’s proposals for dramatic change to NZ employment law, especially after hearing how closely linked the port’s performance is to NZ economic success;

The growth in refrigerated container use for NZ’s fresh produce exports means POT provides 2,634 power points on site and at peak times must also use portable generators;

The board targets a minimum return on investment of 8.50% before committing new capital to development, so shareholders should be very pleased every time they read about expansion;

And my favourite, other than location the Chairman describes the port’s greatest competitive advantage as being its people, and robots not artificial intelligence.

With more effectiveness than Donald Trump, the Port of Tauranga is continuing to make NZ great.

Household Wealth – This is just one of many anecdotal pieces of evidence, but it was interesting enough, and has enough ‘warning value’, that I thought I’d insert a brief comment.

US Household wealth has expanded at a far faster rate than the US economy (GDP measure) between 2011 – 2018.

The two lines trace each other very well in the years between 1951 – 1996 with variation of near 0%.

The wealth data lifted faster around the tech boom until 2000 (approx. 13% variation) and also during the US housing bubble funded by corrupt mortgages between 2004-2006 (31% variation).

Today the gap is a 48% variation, which is confirmation that the market is stretched, when looking through yet another lens.

EVER THE OPTIMIST– An item of hope for old style media companies; The UK’s Financial Times now insists that readers answer survey questions if they wish to read online articles.

They don’t want a subscription from me, that I wouldn’t pay, they want information from me that they can aggregate and sell to advertisers.

Good on them.

I once said to an Editor that I’d pay for high quality articles that are time consuming to produce but I suspect the audience for such content would be too limited to be profitable.

This new approach by the Financial Times looks more likely to be successful.

INVESTMENT OPPORTUNITIES

Kiwi Property Group – is keeping the late 2018 bond issuance conveyer belt operating and announced a new 7-year bond.

It has announced a minimum interest rate of 4.00% and we have a mail list for investors wishing to participate in this offer.

This will be one of the ‘fast moving, booked by contract note’ bond offers.

KPG is paying brokerage, so clients do not pay brokerage on this 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

Chris will be in Auckland on Tuesday October 30, based in Albany, and Mt Wellington on Wednesday, October 31.

Kevin will be in Ashburton on 31 October and Christchurch on 8 November.

David will be in Lower Hutt on Wednesday 7 November.

Chris will be in Christchurch on Tuesday 13 & Wednesday 14 November, in Nelson November 19 & 20 (am) and in Blenheim November 20 (pm) & 21 (am).

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 22 October 2018

Michael Bloomberg is beginning to express some interest in running for US President in 2020, as a Democrat.

This is useful and interesting within the same breath.

Useful because it reminds us that whatever one thinks of Trump, his time at the helm is temporary.

Interesting because prior to 2007 Michael Bloomberg was registered as a Republican voter. This shouldn’t trouble anyone in my view because globally the public’s political expectations have changed so much that party labels from the last century are becoming a little redundant.

It’s just an opinion from a great geographical distance but I happen to think Michael Bloomberg would make a good President for the US, if he can avoid being drowned by the political machine.

He’d certainly be better than Kanye West!

INVESTMENT OPINION

Populism – Politics has always been a popularity contest but in recent years the battle for votes has moved to a point where policies requiring long term commitment to difficult tasks are often discounted completely from a manifesto.

In fact, Trump is evidence of ‘manifesto fluido’ proving that either leaders, the public, or both have very short term and selfish attention spans.

In response, it is all the more important that some of our critical institutions, such as the central bank, and NZ Super Fund, are left to operate with near complete independence from government itself.

Their tasks are always very long term and can only be ruined by short term political opinions.

We don’t appear to have interference problems in NZ, and the US Federal Reserve should have no trouble swatting away Donald Trump tweets, but Turkey is an evolving example of how quickly a situation can become rotten (amongst many others).

Asset Allocation – Did the recent share market price fall see you scared about value being lost, or excited about the prospect of buying more businesses at cheaper prices?

Your response should help you to understand the current risk positioning of your portfolio and may encourage some changes.

The emotional aspect of your reaction would have been low if you invest according to your own investment policy, relative to which you can compare your actual portfolio.

If the dramatic headlines from a week or so ago were emotionally disruptive for you it discloses the lack of an investment policy, which we would clearly encourage you to develop with a financial adviser.

I was prompted to write this paragraph after witnessing some trading that was surprising in nature. For example, imagine a person who chose not to sell a few Synlait shares (SML) when the price was above $12 but last week developed an urgent need to sell SML shares at $9.50.

If you felt a little scared, may I suggest that you ensure you have some investment rules in place to operate by.

If you were excited by the investment opportunity, good on you for having a developed investment process, and remember that often there is value in patience.

Length of failure – One or two recent items that I’ve read remind me of the importance of avoiding investment failures. (sticking to the obvious? – Ed)

Not only the obvious reason of trying not to lose a large portion of the capital originally committed to the investment but also the insidious waste of value through excessive time in tackling the possible resolution of the failure.

The fees paid out to professionals over very long periods crush most of the potential for financial recovery and the time value of money does the rest.

One article covered the UK’s Royal Bank of Scotland, whose CEO Ross McKewen is incidentally another Kiwi from the talented group of people my career has overlapped with (briefly at First NZ Capital).

Side thought – There are a lot of clever old workmates sitting in some very big chairs now, while I sit in a small chair at the beach just North of Wellington. Mmmmm, I think it best that I avoid comparisons.

RBS ‘failure if not for government assistance’ cost UK taxpayers GBP £45 billion at a share price of GBP £5.02 but 10 years later after receiving no dividends the government sold some RBS shares this year at a price of GBP £2.71.

RBS declares itself now to be on normal financial settings for a bank and has just paid its first dividend since 2008 of 2 pence per share.

Today’s share price is £2.41.

£5.02 earning a modest 4.50% (UK government bond rate back in the day of November 2008) would now have compounded up to £7.51 (no tax implications, just gross debt costs to UK tax payers).

That’s a 68% loss of value, for a business that managed to survive.

Meanwhile, Babcock & Brown’s liquidator sent me their latest update including a summary of projects and costs each quarter over the past 10 years and the timeline and probability for a modest payout ahead.

The BBL liquidator is sitting on AUD$24.9 million and facing three outstanding claims against this in the courts.

Don’t hold your breath.

Babcock & Brown failed on 13 March 2009. Between the Voluntary Administrator and the Liquidator AUD$5.75 million has been retained in fees and expenses.

BBL’s liquidator explains that if the court judgments are concluded by November 2018, then the required sequence that he must follow would result in a payout in February 2020 (judgment plus 13 months).

Before you get too upset about liquidators milking the dead beast, they also draw our attention to the extra-ordinarily slow legal process; something Dr Bryce Wilkinson recently highlighted as a problem for serving justice in NZ. The following is copied from the B&B liquidators website regarding a judgment they await:

At the time of preparing our Annual Report to Creditors dated 16 November 2017, the Court had advised us that judgment in the Masters, Broome and Wilhelm proceedings would be delivered in late November 2017, which would allow us to commence the finalisation of the Liquidation.

Unfortunately, and after we had issued our report, we were advised on a number of occasions by the Court that judgement would be handed down in January 2018, then February 2018, then May 2018, then late August 2018. On 30 August 2018, we were advised that Justice Foster will be unable to finalise his judgment for at least two months, and that we will be updated if and when further time is required.

It seems clear that the laws of the land and justice systems will not be the saviours of our residual asset values.

I already have a hollow, valueless, feeling for investors holding shares in CBL Insurance where it’s clear that enormous value has been lost, which must include some spectacularly bad corporate decisions, but the ongoing secrecy and disagreement between regulators about the way forward will ensure that this corporate failure will remain under court proceedings until beyond the point of my retirement (I am 52 years of age).

Sure, it’s rather obvious that we should all try to avoid investment failures but even if a failure has some residual asset value, more often than not this value will be eroded by the costs of receivership, liquidation and time.

Chris’s imminent book, covering the era of South Canterbury Finance, will present to you how statutory managers, receivers and liquidators can themselves cause spectacular damage to the residual assets of a failed business.

Referring back to the UK value comparison, we are reminded by the incessant rise in the value of reliable (and perhaps compounded) revenue not to stick our necks out too far as we seek returns of ‘reliable + X’.

INVESTMENT NEWS

Steel & Tube – Two weeks ago, after several weeks of private interaction between the companies, Fletcher Building approached STU with an unsolicited offer to buy STU at $1.70 per share.

STU directors responded as if their honour had been attacked and they quickly denounced the FBU offer as far too low.

I commented at that time that I hoped the faux offence was a negotiating tactic and that STU was continuing to negotiate with FBU about what they both might agree was a fair price for a transaction to occur.

STU does not enjoy a good footing for explaining added value to its shareholders after recent years of poor performance.

FBU promptly returned to its ‘war room’ to consider what their final position would be in their attempt to purchase STU; the answer was $1.90 plus agreement that a final 5 cent dividend could be paid out to current STU shareholders.

This offer was presented to the STU board on Friday 12 October.

FBU shareholders should be pleased because they are witnessing a business that is now very clear on its strategy and on industry value which is supporting prompt decision making with respect to new risks or opportunities.

This time STU directors responded in a luke-warm fashion declaring that the offer was below their perceived value of $1.95 - $2.36 and that they’d seek an independent opinion on value and revert in due course.

Then, the STU board continued to publicly invite other potential buyers to line up and compete with FBU as if there was a TradeMe auction underway!

This was disrespectful to FBU who have subsequently explained that they were initially seeking private negotiations.

FBU’s reaction was to withdraw its offer on Monday 15 October. This is another good sign for FBU shareholders about the clarity that is now present for FBU directors and senior executives.

FBU has concluded that STU wishes to play games with their offer and they’ll not leave this option available to STU; FBU has better things to do with its time and money.

FBU had already canvassed opinions from major STU shareholders and gained support from them, subject to settling on a fair share price. I doubt STU spoke to these same shareholders, and if not they’ve made a strategic error.

After what FBU describes as five weeks of negotiations STU is negotiating as if they require months to make decisions, which discloses a weaker governance standard and strategic plan or knowledge about market position than FBU is displaying.

One of STU’s largest shareholders, Milford Asset Management, also acted swiftly to STU’s rejection of FBU and has sold its 15% shareholding to NZ Steel at $1.75 (20 cents below FBU’s improved offer).

Do you recall my comments last week about the market’s value of Tilt Renewables? Money talks. Tilt was trading at $2.30 and STU shares traded in very large volume at $1.75.

STU directors now have a lot to prove to their shareholders, and must do so over a very short time; the future value of the FBU offer looks a little like this when I apply a modest opportunity cost of 4.50% after tax returns:

2019 - $2.04;

2020 - $2.13;

2021 - $2.23;

Today’s share price is $1.53 (time of writing)

My personal view is that STU directors have let their egos get in the way of a very real proposal for consolidation within the NZ building sector and if I’m right the STU directors will not deliver rising profits, dividends and STU share price to compete with my theoretical future values.

STU directors were under-prepared for this negotiation with FBU and it shows through the behaviour of their responses.

The counter argument is that FBU is taking aggressive advantage of STU’s situation.

I’d respond by saying, ‘as they should, and STU should always be as prepared as FBU is now to ensure an effective negotiation takes place’. ‘Aggressive’ is an emotional term and it should play no role in a business negotiation; emotion is reserved for headlines.

In the past Mrs Warrington would get quite upset with me for placing time limits on property negotiations and withdrawing offers when the other party started demanding 1-2 weeks to make decisions.

I would respond that both parties are (or should be) prepared for this negotiation; they’re both in the market and should be ready to make decisions. If we grant them an excess of time they will use it to our disadvantage.

You can imagine the response I would get.

You can also see where I sit on this FBU vs STU situation.

It’s nice to finally see two building industry businesses seeing opportunity for success in the sector, but I am underwhelmed by the current governance of one.

Inflation – This data barely rates a mention, but New Zealand’s third quarter headline CPI was above the expectations of most at +0.9%, bringing it back up toward the 2.00% central point of our targeted range.

It was influenced by various ‘one off’ items, so the Reserve Bank has left its core inflation assessment at +1.70% over the past year.

This will not result in a changed opinion for the NZ Official Cash Rate.

Fred Dagg – under the heading ‘We don’t know how lucky we are’, a recent HSBC survey ranked Singapore as the best location for expat workers, just ahead of Canada, Switzerland and New Zealand.

Esteemed company indeed.

EVER THE OPTIMIST– If Western share markets manage to hold onto ‘unchanged share index levels’ for the 2018 calendar year, whilst the Chinese market falls 25% and several of its superstars (such as Tencent) retreat to share prices of 2016, that would be a satisfying performance.

ETO II – It was good to see Nelson irrigation users step in with their own funding proposal after the private investors offers were rejected as seeking excessive returns relative to risk.

The primary producers are the best placed to understand the potential for production increases from better irrigation and thus have a better knowledge for pricing the risk and reward scenarios for investment in the Waimea Dam project.

It’s nice to read about progress in the irrigation space. I understand another in Canterbury continues to make progress with its funding too.

INVESTMENT OPPORTUNITIES

Infratil –new bond offer, including terms of 6 years and 10 years (5+5 year periods).

The Infratil offer closes this Friday so now is the final opportunity to act if you wish to invest.

Please contact us urgently if you wish to invest but haven’t already done so.

Other Bonds – we expect two and perhaps three more bond offers between now and December, so please keep an eye on this section of Market News or join our email list for notifications.

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

Chris will be in Auckland on Tuesday October 30, based in Albany, and Mt Wellington on Wednesday, October 31.

Chris will be in Christchurch on Tuesday 13 & Wednesday 14 November, in Nelson November 19 & 20 (am) and in Blenheim November 20 (pm) & 21 (am).

Edward will be in Remuera, Auckland on 26 October.

Kevin will be in Ashburton on 31 October and Christchurch on 8 November.

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 15 October 2018

Before Jacinda Ardern gets energised against our fuel supply companies and how effectively the government uses our road taxes, she should go on a road trip (like Simon Bridges? – Ed) and review the very poor state that our roads are actually in.

I suspect the latest tax increase on fuel has gone into paying for more road cones around scruffy patch work and not into road development or a proper maintenance programme.

INVESTMENT OPINION

NZX – I was unsurprised that several of you sought our thoughts on the extra-ordinary situation surrounding the NZX at present and distracting them from their more important foci.

I find the recent public interaction between a hyper-active fund manager and the NZX quite remarkable, and a complete waste of energy for the NZX and all other observers.

The demands issued by the fund manager seem irrational to me; armed with their (reported) 2.3% shareholding they are demanding three seats on the board, a new strategy (asset sales), a planted employee and refunds for the recent trip to New York.

Why does this fund manager have enough spare time to dream up these highly unusual demands? Surely, they are too busy actually managing their investors’ money properly across a wider portfolio.

The fund manager is behaving as if they have a dominant shareholding or control discretionary proxies from 50.1% of the NZX share register, which I doubt.

Looking at the register the total number of NZX shares held in the NZ Central Securities Depository (an environment used by professional fund managers) adds up to 42% of NZX shares, so the grumpy fund manager would need 100% support from all major fund managers to be expressing the robust views that they offered last week.

It’s not credible that they have such support from all fund managers.

The only item that gave me pause for thought was that one of the names listed as being offered as a replacement director for the NZX is a very credible person.

‘Why would this person agree to such an irrational approach’ I thought?

Interestingly, another of the fund manager’s directors is a past Chairman of the NZX. Presumably he spent some time explaining to his new fund management team why they performed poorly during his time at the helm also.

The fund manager is inappropriately trying to simultaneously exert governance and executive control over a business they neither have the shareholding nor role to exert.

With respect to strategy they’d like it if the NZX exited the fund management industry. I’ll bet they’d like this, because they are a fund manager with their own selfish strategies and motives in this space.

NZ investors and financial advisers confirm that they want NZX Smart Shares (Exchange Traded Funds) to exist, witnessed by the 32% growth in funds under management over the past 12 months. Since when is 32% growth in the scale of a business (a division of the business) not a good thing?

The NZX was well focused with its strategy to introduce the ETF Smart Shares business to its mix.

The fund manager wants the NZX to exit certain market operating activities (Dairy Derivatives) yet the NZX is a markets operator and in the case of dairy it is one of this country’s largest sections of the economy and thus it is supported by deeper capital market activity.

The fund manager wants NZX to halve its executive staff, as if they know all the logistics being delivered by the company and conclude that the NZX CEO and board are currently happy to carry an excess staff loading of 100%.

Again, this isn’t a credible conclusion.

The fund manager wants to micro-manage day to day activity at the NZX and deems the trip to New York unnecessary. This wasn’t a conference to stare at their navels and ponder the future, it was finalising the new partnership agreement with NASDAQ.

Thankfully they haven’t expressed a view about NZX use of courier bags, cell phones and the wide variety of tea bags in the kitchen.

Apparently, the fund manager stated that if the NZX followed their strategy the NZX’s shares would be worth more like $1.62-$1.89 in a couple of years.

By sticking their necks out the fund manager makes it clear they are very committed to the validity of their opinions. You’d need to be.

I don’t know the basis of these price forecasts, but as you’ve seen from the various opinions about the value of Tilt Renewables one is also able to throw around a variety of implied share prices for the NZX based on differing spreadsheet assumptions.

If the fund manager is genuinely keen to make massive changes to the NZX they should act on their confidence and make a takeover offer in the market to gain control of the business. If they offer a high enough share price, I’ll consider selling my shares to them.

Until then, I have better things to do with my time than listen to corporate activity that aligns with the behaviour of a young child who isn’t getting their way on a subject they are very emotional about.

Oil Price – The traffic that ‘gets in my way’ has not decreased as a result of the higher fuel prices so travellers have clearly not changed to public transport or bicycles as regulators have hoped.

Oil producers are helping such travellers, delivering the highest daily volumes ever recorded (not running out or rushing to get out? – Ed).

In choosing to stick with their car travellers are also agreeing to a marginal decline in their discretionary spending budget, which in turn will have a wider impact on economic activity (sales) for other businesses.

Slightly weaker discretionary spending is hardly good for businesses that have already lost confidence in their forward-looking performance.

The government shan’t be concerned because GST will still flow in, probably at a higher rate because it is now sourced to non-discretionary spending.

Again, none of this spells inflation to frighten off fixed interest investors.

INVESTMENT NEWS

Shares down – Initiated in the European time zone on Wednesday night, then reinforced by a 3% decline in US share markets, investor confidence took its biggest knock since February.

Actually, the source of last week’s declines may well have been the ongoing fall in the Chinese market plus China’s surprise decision to inject more liquidity into a troubled banking sector disclosing wider concerns for this important global economy.

Either way, global confidence is becoming more fragile.

Confidence, or lack of it, drives the majority of a market’s volatility.

Businesses can deliver strong performances and still see their share price decline, as Chorus experienced on Thursday with ‘record number of new fibre connections’ but a 1% decline in share price.

This market move will be another useful stress test for investors to contemplate their asset allocation mix and investment policy settings.

Steel & Tube – Fletcher Building increased, then withdrew its offer for Steel & Tube shares.

I’ll express my point of view next Monday as this is an interesting development but suffice to say STU board has a lot to prove now.

Tilt Renewables – Infratil and Mercury Energy have followed one of the paths I described as possible and advised TLT shareholders that they will not be increasing their takeover price from $2.30.

Personally, I didn’t see any need for them to do so in this environment. The wider market doesn’t either, positioning TLT share price at exactly $2.30.

With this clarity they have agreed to extend the closing date for their takeover, now at 29 October.

TLT shareholders may benefit from re-reading our comments in Market News on 1 October; one form of potential uncertainty has been removed.

The decision is thus slightly simpler:

Sell or not sell at $2.30;

To not sell is to confirm that you are happy to support additional investment in the company and are indifferent to the share price on market in coming months. (albeit hoping for a higher price).

Bank risk– The central bank of Thailand (BOT) is following the now ‘way back’ lead of the Reserve Bank of NZ and imposing Loan to Value restrictions on new mortgages.

BOT is imposing an 80% LVR restriction on properties valued above the equivalent of NZ$500,000 (THB$10 million) and on all subsequent properties owned by the same person.

BOT became concerned about the rising level of debt relative to house values, which are also rising like most other developed nations, and the rising levels of debt relative to income.

Both developments increase the risk carried by the banking system and the central bank has concluded that those risks are now too high.

I’d quite like it if NZ led the way again and introduced a Debt to Income (DTI) macro-prudential regulation to further enhance our central bank’s control over the debt risks our public have been willing to use (and banks to accept).

I’d certainly prefer to see DTI introduced before the central bank considers reducing LVR limits.

Rising property prices can place a false sense of security over bank risk assessors via decreasing Loan to Value ratios but this confidence could soften, fast, if affordability changes on the large loans held (interest rates up, or incomes down).

It is my view that the better our tool bag of macro-prudential tools are the less volatile our Official Cash Rate will be, which is a good thing.

Xero – A recent debt offering by Xero, in Singapore, reminds investors of the importance to read offer documents and understand terms and conditions.

The initial headline described Xero issuing ‘senior unsecured convertible notes’ to borrow US$300 million.

However, mixing the terms ‘senior’ and ‘convertible’ is inadvisable in my opinion.

Once you look further into the terms you discover a more complex maze of transactions linked to repayment of the loan with the issue of shares (convertible notes).

The interest rate is simple enough at 2.375% in US dollar terms. However, there is a lot of information in the structured agreement relating to how the loan will be repaid, linked to the XRO share price (including shares at a price of US$46.34).

As part of the complex structure Xero is both selling and buying call options on their own shares, then lending XRO shares to the investment bankers who are counterparties to these options transactions to ensure minimal (or nil) dilution to other XRO shareholders when this loan is repaid with the issue of new XRO shares.

For a modest sum of money Xero has protected themselves against having to issue shares at US$46.34 (AUD$63.70) but left this risk open if the share price rises above US$60.60 (AUD$83.30), whence XRO shareholders may experience dilution.

Xero seems to be of the view that if the XRO share price is above AUD$80 in 5 year’s time I’ll be a satisfied investor even if I suffer small dilution as a result of this debt issue; they’d be correct with that conclusion.

 

Nonetheless, the message here is to always take some time to read the terms and conditions of any offer that you are considering participation in, especially if it introduces some unusual terms and conditions.

Future cash flow for sale – After NZ Super funds comments about borrowing from the future, I read an article that reported that old rock legends (or their managers) are doing something similar and leasing future royalties, as opposed to selling them which happens often.

Rising sales for these excellent bands, from an era that my kids are now discovering and paying more money for, are increasing the probable future cash flows of these bands, which is in turn providing the music rights owners with a higher value asset in today’s terms.

The price of a bond is the present value of known future cash flows, at an agreed interest rate (say 4%).

The present value of music royalties is based on uncertain future cash flows, measured at a higher rate of return (say 8-10%) to reflect the likely volatility of music sales, but rising future cash flows means more cash today.

If the author of ‘Money For Nothing’ (Mark Knopfler of Dire Straits) sold only a defined window of music sales (say 10 years) he may well be capitalising a lot money again (performance brought forward) as a result of renewed consumer trends and thereby receiving ‘Money For Nothing New’.

Any rock legend who wasted his/her cash from the 1980’s and 1990’s, and is technically broke, may well discover a new vein of cash linked to the changing consumption of this generation’s youth.

It almost carries a definition of the ultimate perpetual bond with variable returns!

Artistic value – Whilst on the subject of money for art and how much you might pay, Banksy has again taunted the art world’s perceptions of value with his latest stunt of creating a picture, publishing it widely and selling it at auction (US$1.4 million), but then immediately post the auction, via remote control, he shredded half of the art piece (it fell through a shredder hidden inside the picture frame).

His statement, in my opinion, is to prove the absurdity of market valuations because it is likely that he has now made the art piece more famous and thus more valuable, yet he intentionally destroyed 50% of it.

Clearly one needs far more income than one can spend to buy investments with value linked solely to scarcity (no productivity or income), but does that make such investors ‘greater fools’ or intelligent at assessing market behaviour?

Banksy would define them as greater fools, always hoping they are not the greatest fool.

All I hope to do is remind you all that emotion plays a role in the pricing of many assets, including various investments within our portfolios.

EVER THE OPTIMIST– The NZ government operating surplus continues to surprise to the upside (now at $5.5 billion), partly via higher tax collection and partly delayed spending.

The higher tax collection is a healthy sign from corporate profits and higher employment numbers.

Now though, the wide benefit of this revenue is dependent on the quality of government spending (targets and effectiveness), otherwise it is wasted energy delivered from a robust economic period.

If you’re curious, Dr Bryce Wilkinson (previous workmate of mine) wrote a good piece on government spending for the NZ Initiative.

ETO II – NZ guest nights in August were at new records and the year to August was nearly 40 million nights (+2.5% on previous year), which implies gross turnover between $5-8 billion by my math.

This data excludes private property rentals (think AirBnB) making the real total an enormous amount from our rising tourism industry.

We all see the tensions derived from the elevated tourist activity but it is great economic news and part of our robust employment and consumer confidence numbers.

INVESTMENT OPPORTUNITIES

Infratil – new bond offer, including terms of 6 years and 10 years (5+5 year periods).

Holders of the maturing Infratil bond (IFT180) have the opportunity to reinvest in the new offer (using the Exchange Form) but require a firm allocation to do so.

The interest rates have been set at:

6-year term – 4.75%; and

10-year term – 4.85% for the first period of 5 years (then reset for years 5-10).

New investors still have access to the 10-year bond, and will know tomorrow if Infratil will re-open access to the 6-year bond.

The offer document can be downloaded from our website; application forms must be delivered to us.

Port of Napier –Hawke’s Bay Regional Council is considering the merit of selling up to 45% of the Port of Napier via an Initial Public Offering and listing the company on the NZX.

We hope this opportunity makes it to the market.

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 will be in Remuera, Auckland on 26 October.

Kevin will be in Ashburton on 31 October and Christchurch on 8 November

Chris will be in Auckland on Tuesday October 30, based in Albany, and Mt Wellington on Wednesday, October 31.

Chris will be in Christchurch on Tuesday 13 & Wednesday 14 November, in Nelson November 19 & 20 (am) and in Blenheim November 20 (pm) & 21 (am).

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 8 October 2018

I am developing a pet gripe related to technology.

All those who provide service to me are dead-keen to serve me via the internet, but, the majority ask me not to communicate back with them via that method.

I understand the desire to keep communication costs down but if you want me to be a customer don’t issue me with emails and text messages that I cannot reply to!

This is another sign that Artificial Intelligence is just that, artificial, and in no state to compete with good personal service. (let alone drive cars – Ed)

INVESTMENT OPINION

Italian Job – I don’t think the Italian populist movement government could have been more overt in its efforts to upset the European Union than to have passed the budget that it now has.

They have presented the proverbial fingers to Brussels.

The prior government had been targeting a 0.5% budget deficit for 2019 and was hoping for a balanced budget by 2020.

However, changing the government is an Italian pastime and the latest of the ‘new’ Italian governments has budgeted for a 2.4% deficit in 2019 and plans to continue the largesse in the years that follow.

They appear to believe they are starting from a clean slate, and not with a government debt at 132% of GDP and private debts at 170% of GDP.

The Italians are feeling so flush with funds they are planning tax cuts, a higher basic income for the unemployed and scrapping plans to increase the retirement age.

They declare they have abolished poverty, but I suspect this will prove to be an unproductive hand out instead of the more effective hand up.

Italy is trying to kick their version of the Greek ‘financial can’ further down the road. They see that everyone else is getting away with aggressive financial behaviour so why shouldn’t they be in on the fun.

The EU, via the European Central Bank, helped the likes of Greece, Ireland, Spain, and Portugal when they threatened financially disruptive outcomes. So too does the International Monetary Fund when they smell financial trouble; look at last week’s US$57 billion rescue loans to Argentina (IMF’s biggest ever) in response to that country’s poor financial management.

It seems that no regulator is willing to enforce a cost consequence for poor decision-making.

Negotiating tactics of breaking from the Euro and returning to the Italian Lira will be used, and ignored by the EU, steadfast in its view to hold the line on the Euro.

The EU will talk a tough hand for a while, and pretend to be holding four aces, but they will ultimately cave in like a dried-out sandcastle and provide Italy with financial support required to avoid debt default.

When they do offer financial support, I hope the EU refuses to buy Italian bonds on market (or issue new debt) without applying very high interest rates, such as 10% or higher. The EU wide tax base at least deserves the respect of a realistic return for risk.

Any financial market risk takers who currently own Italian government bonds should be forced to accept some of the pain of imminent Italian debt default that would surely happen without EU support. They value or sell their Italian bonds at 10%+ also.

The current yield for Italian 10-year government bonds has lurched back up to 3.00% (from a previous low of 1.50% when market naivety ruled) but this isn’t anything like enough return for the Italian Job risk.

If there isn’t to be a default on Italian bonds, guess who pays?

Yes, the taxpayer pays, as the name defines, and I don’t think the populist voters have connected the dots between voting and paying; which is a global problem.

And, if you had higher debt costs coming your way would you seek to cut your income?

The Italian government is pledging to reduce Italian taxes from a 43% high setting to 20%.

I’m certain that my kids would conclude that running one’s debts up and their income down isn’t a winning strategy.

For economic perspective, Italy’s economy is large, larger than Russia or Canada for example.

The UK and Brexit will retain the European headlines for the next 6 months, but they will then be bumped off the front page by Italy’s problems, in my view, and not in a good way.

The inappropriately short-term focus being displayed by so many nations voters cannot last. The periods of survival for such incompetence will vary but surely the outcomes will be the metaphorical equivalent of those who live on the street in NZ. Perhaps Venezuela is a better comparison, because it’s real and at a country level.

I am off to Argentina in two weeks and I look forward to learning how their latest poor governance decisions are impacting the wider population.

Argentina, Turkey and Venezuela are all serious national problems, and Brexit will be disruptive, but Italy’s rising financial risk is bigger than each of the others.

I haven’t tied this Italian concern to an investment thesis but I wouldn’t be in a hurry to over-weight investment in Europe for now.

Still unlearning – You’d think that if the country’s most ‘valuable’ company doubled its wage costs it would imply a widespread drag on corporate profits (as others respond to compete for employees) and thus the share market would decline for a while, but no, not today.

Amazon has conceded, to the rising political tension circling around its pay rate of US$7.25 per hour, and from next month will pay its workers US$15 per hour.

Amazon shouldn’t feel like a leader of the virtuous because they were not first to move, another behemoth retailer (Walmart) moved higher long before them, but the decision deserves respect all the same and between them will widen change across America.

Is Trump making America great again, or is it business that is doing so?

Amazon and Walmart want their employees to enjoy some more of that greatness.

The US Federal minimum wage remains US$7.25 but this will come under pressure politically as the country’s largest employers reset what a minimum pay really is.

A 100% increase in hourly pay speaks volumes about just how far the US had let pay ‘inequity’ slide during the past two decades.

So, with huge increases to labour costs, gradual increases to interest costs and disruption to trade flows why is the US share market threatening to set new all-time highs?

What do I need to unlearn here?

Are investors considering the potential for higher personal pay rates to increase debt reduction alongside consumption, thus developing a virtuous spiral for the US economy?

Judging by the information that surrounds me, I have difficulty believing that the population will reduce its level of personal consumption when more discretionary money arrives in their wallet because typically the opposite happens.

The only time I have seen extreme care taken with discretionary funds is immediately following crises, with the GFC of 2008 the most serious, and even then financial anxiety only lasted about 24 months before debt fueled consumption was on the rise again.

If ‘we’ are willing to increase consumption with debt, we surely will with higher pay in our pockets.

Unless, I have something to unlearn?

Fletcher – like all investors I was astonished at how FBU had failed to capitalise on the very busy construction and housing sectors, but they may just get another bite at the apple; the residential portion anyway.

There is so much political energy behind the push to build more housing that any competent building business should profit from their involvement.

Given the Housing Minister’s desire that at least half of his target 100,000 new homes should be sourced to prefabrication methods of building, and there are only a small number of businesses with the scale to deliver, surely Fletcher Building is back on the front of its next wave?

With a good deal of bias, I hope I am correct. Yes, I own a few shares, but I’d also like to see access to housing at credible prices for my kids.

Mind you, the Hon. Phil Twyford has far more riding on the outcome than I do.

Fletcher Building II – Here’s some more evidence that FBU considers itself to now be on the ‘front of the wave’; they made an unsolicited offer to buy Steel & Tube at a price of $1.70 per share.

STU directors promptly rejected the offer stating that it ‘significantly undervalues the company’.

I hope they’ll forgive me discounting their faux offence as a negotiating tactic because their foundation for adding value is poor over recent years, so it takes quite the leap of faith to believe that the business performance ahead is assuredly ‘significantly more valuable’.

I must disclose that I own a few STU and I supported the recent capital raise in the belief that the company has indeed traversed its prior poor form and has good prospects ahead, but as any gold miner will tell you ‘prospects differ from gold’.

What I’d really like to see here is a long-term supply agreement between the two companies.

Why didn’t FBU buy 5% of STU shares on market a few months ago, then underwrite the recent STU rights issue to try and accumulate a larger investment, in return for a negotiated trade supply agreement?

It’s all very easy for me to say from the sidelines, after the event, but FBU and STU knew what their forward-looking requirements were, so in my view they should have been talking long ago.

Maybe they were?

I’ll never know, but, what we now do know is that FBU wants increased steel supply and prefers the idea of owning a local supplier to meet its requirements.

As a blinkered shareholder of both entities I could paint a picture that today’s development is good news for both companies.

INVESTMENT NEWS

Trade – The US continues to prove that it can achieve new trade agreements and with Canada’s late acceptance NAFTA has become USMCA (US, Mexico, Canada Agreement).

They understandably wanted to move on from ‘NAF’.

That’s the local neighbourhood for trade settled down, now Trump can concentrate his trade focus on Europe and the wider Pacific (TPP 2?) before positioning the full glare of his spotlight on China in 2019 or 2020.

Borrow – The recent performance report from the NZ Super Fund is worthwhile reading for investors. (https://www.nzsuperfund.nz/)

Whilst it was nice to learn that the managers of ‘our’ fund are doing a high-quality job in terms of asset selection and financial performance of those investments the greatest value for us was the reminder that the returns we have all been enjoying cannot be sustained in the years ahead and we must all prepare for lower average returns.

Their Chief Executive, Matt Whineray, used understandable terms when he said, ‘we are borrowing returns from the future’.

With interest rates between 2-4% (generalisation) and apparently no longer falling, and GDP growth also between 2-4% across various parts of the global economy, it is not realistic to expect recurring returns between 8-12% that have been enjoyed in recent years.

Some of the higher returns can be attributed to recovering from the Global Financial Crisis when we discovered that all was not as bad as may have been feared for economic damage.

Then, more of the higher returns secured ‘now’ might be attributed to the capitalization of much lower interest rates, through the increasing value of ‘old’ high interest rate bonds and the present value of many businesses future cash flows (visible in rising share prices).

Lastly, the swing from pessimism, through neutrality and on to a point of optimism has shifted share prices from discounts, to fair value and now to premiums, even where a business’s performance hasn’t changed.

I would describe it as being like a stretched rubber band, now some distance from a comfortable equilibrium.

Matt more helpfully described it as borrowing returns from the future, presented into today’s portfolio performance.

When a person uses debt to finance personal consumption they are bringing forward that consumption and the debt must be repaid.

Incidentally, low interest rates have boosted private debt levels globally, often for consumption (rather than investment), and this is causing concern about unsustainable consumption levels being enjoyed by businesses and the potential for investment losses from a lift in defaults on debt repayment.

Neither outcome is good for business valuations.

If we borrow returns from the future, by capitalising the many optimistic scenarios, this ‘debt’ must also be repaid, but in this case, it can happen by way of an extended period of below average returns (following this period of returns well above a logical average). It won’t simply be a slump in market value/pricing.

Certainly, the prospect of further capitalising lower interest rates is ‘slim to none’, so all other assistance for market value must come from wider economic growth and specific company outperformance.

Expecting high levels of economic growth in the current global settings seems irrationally optimistic to me, so I don’t expect tidal assistance for a portfolio from this influence. That only leaves specific company performance to drive a winning portfolio but identifying ‘winning horses’ is the hardest part of investment management.

The NZ Super Fund has a tremendously long-term outlook, yet it makes it clear that it is reducing its risk profile in the current market conditions to patiently wait for better opportunities in future.

If you have the time, look at the NZ Super Fund report(s), they make good reading for investors.

Fed Balance sheet – The US Federal Reserve reports the continuation of its monetary policy tightening both through its higher Fed Funds (overnight) rate, but also the progressive decline in the scale of its balance sheet.

The Fed’s bond portfolio reached US$4.5 Trillion at one point, but the most recent declaration was down to US$3.997 Trillion and has an expectation of declining at an average rate of US$50 billion per month.

It will be good news if the Fed can hold onto this strategy without disruption for an extended period because the further they can reduce the size of their balance sheet the more effective influence the retrieve to provide financial support for any future distress that requires their involvement.

The progressive change to the Fed’s balance sheet will be an important marker for the ongoing improvement in US financial conditions.

EVER THE OPTIMIST– After using dire warnings about shut down potential in their negotiations for lower electricity pricing Comalco (NZ Aluminium Smelter) has announced that it is to re-open the fourth pot at the Tiwai smelter and increase aluminium production.

It reinforces for me why Mark Binns was correct with his firm negotiating stance when at Meridian and the weakness of the government’s approach when they agreed to provide a subsidy within the new agreement.

Nonetheless, it is good news for Southland’s economy and it had better be good for the NZ corporate tax take too.

ETO II – One doesn’t like to profit at another’s expense, if the other has been hit by influences beyond their control, but, from a NZ Inc. perspective it is nice to see our Merino farmers receiving very high prices for their wool.

Last month’s price was 25% higher than the same month last year and isn’t far from double the long-term average price.

Our condolences go to the Australian farmers who have been forced to cull their stock in response to climate issues. Although this does remind me of one of NZ’s competitive advantages (water) even though we try our hardest at times not to recognise it and manage it well.

INVESTMENT OPPORTUNITIES

Infratil – has launched its new bond offer, including terms of 6 years and 10 years (5+5 year periods).

Holders of the maturing Infratil bond (IFT180) have the opportunity to reinvest in the new offer (using the Exchange Form).

The interest rates have been set at:

6-year term – 4.75%; and

10-year term – 4.85% for the first period of 5 years (then reset for years 5 to 10).

All new investors are welcome to participate. The offer document can be downloaded from our website; application forms must be delivered to us.

Port of Napier – Great news, Hawke’s Bay Regional Council is considering the merits of selling up to 45% of the Port of Napier via an Initial Public Offering and listing the company on the NZX.

In my opinion HBRC is wisely doing the opposite of Canterbury and Auckland whose councils bought back 100% ownership of their regional ports.

HBRC wants to diversify its own regional investments whilst not constraining the capital demands of the growing port.

I hope this opportunity makes it to the market.

We have not yet started a list but will do so if this potential deal reaches the point of reality.

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 will be in Remuera on 26 October.

Kevin will be in Ashburton on 31 October.

Chris will be in Christchurch on 13-14 November, in Nelson 19-20(am) November and in Blenheim 20(pm)-21 November.

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 1 October 2018

It’s becoming easier to find anecdotes that support a view of the share market being stretched in terms of pricing.

In the US, insiders, which include corporate officers and directors, sold shares in August and September at the fastest pace in 10 years.

INVESTMENT OPINION

Oil Inflation - Save the planet, or save yourself?

The rising oil price, falling value of the NZ dollar, and additional taxes from central and local government is placing new duress on one’s wallet.

The oil price increase does place one strand of inflation into the mix, but, it is a volatile data point, and is one that the central bank will ‘look through’. The relative decline in discretionary spending power removes inflation pressure more widely and this will be of more relevance to monetary policy setting.

Interestingly, the central bank’s good performance with monetary policy is part of the reason for our higher local oil pricing; RBNZ’s effective use of macro-prudential policies has resulted in fantastic stability for our Official Cash Rate, which now rests at lower levels than the influential US economy.

This item; NZ rates lower than US rates, prompts commentary about its pending return to ‘normal’ (US lower) but I suspect this might be an opinion to ‘unlearn’.

Having NZ interest rates reliably lower than US interest rates is placing downward pressure on the value of the NZ dollar, which in turn places upward pressure on pricing of imports such as oil.

This trend is ‘good’ for NZ if it helps to slow our imports (our trade deficit in August was awful) and increases our use of domestically produced electric energy in the transport fleet.

Wouldn’t it be nice if we had an impressive public transport system (in Wellington – Ed) as another alternative whilst oil pricing is soaring in price (or that we could ride motorbikes in cycle lanes – Ed).

Maybe employers could help keep some of their staff’s transport costs down by considering ‘work from home’ days each week (with measurable productivity), and simultaneously achieve a slight reduction in their city rent?

Uber displays the merit of vehicle sharing, AirBNB proved value in sharing of residential property with travelers, so it also seems logical for commerce to share property use more widely (through work from home schemes).

This started out as a brief comment about my view that the higher oil price won’t be inflationary, and result in higher interest rates, but has turned into a bit of a ramble.

Sorry.

Why Would I? – A client asked me last week; why would I buy those Auckland Airport bonds for so long, at such a low yield, relative to my short-term bank deposits at 3.40%?

Please explain.

OK.

The short answers are:

Diversity of borrower;

Diversity of duration (period of investment);

Liquidity; and

A competitive reward for the risks on offer.

3.51% p.a. may look awful, but it is a fair market yield to lend money to a strong borrower, such as Auckland Airport with its ‘A-‘ credit rating for a 6-year term.

AIAL had no trouble borrowing the $150 million at this yield.

So, the pricing (reward) is competitive.

‘Why wouldn’t I simply lend the money to the bank?’

The bank is a robust borrower, but diversity of borrowers remains wise.

‘Why wouldn’t I simply deposit the money in the bank for 9-12 months at 3.40%?’

You would indeed do some of this investing, but you’d be wise to insulate some of your earnings against the potential for interest rates to fall from here.

‘Fall from here? We’re not far from 0%’

Investors have held that view since the time interest rates fell below 5.00%.

‘OK, I’ll invest in a 5-year bank term deposit at 3.80% instead’.

Sure, you can do some of this investing too, but this has no liquidity (saleable to raise cash) so don’t tie up too much in bank deposits alone.

Liquidity, why would I need that?

Everyone needs to control his or her cash management. If you control sufficient cash you cannot be held to ransom by any of life’s costs or market pressures on the value of your assets.

During the 2008-2009 period of the Global Financial Crisis investors stood near enough to zero chance of withdrawing cash from fixed term bank deposits, yet they could sell government and council bonds, and other than November 2008 they could have sold a strong corporate bond such as those from Auckland Airport.

‘You want me to believe that an AIAL 6 year bond at 3.51% is a winning constituent of my portfolio?’

I didn’t use the words ‘winning’. It doesn’t walk forward all that quickly in value, but it does provide several insurance-like characteristics at a relatively low opportunity cost.

‘Low cost?’

Sure, if you hold this bond in your own name without the impost of annual management fees (all investment managers own bonds like these) then the apparent cost to you is about 0.30% p.a. relative to an illiquid bank term deposit.

If your fund manager owns it for you the implied gross return to you is more like 2.51% p.a.

This fund manager item opens a whole new angle, for another paragraph (see below).

So, there you have it; AIAL bonds yielding 3.51% are fair value and do have merit within most fixed interest portfolios. (they’re not convinced – Ed)

Fund Manager Fees – Regular readers will need to accept my apology for the repetitiveness of the content of this paragraph.

We do not see merit in investors paying high annual fees (0.875% - 1.25%) for the management of fixed interest investment allocation within a portfolio.

You can all do the math, as I have shown above: If your fund manager invests in AIAL 6-year bonds (for you) at 3.51%, then what you receive is 2.51% after fees (my 1.00% annual fee mid-point).

To lose 25-33% of your reward in this low yield environment makes no sense at all.

All investors can arrange bank term deposits and can ask us to provide them with access to a wide array of bonds, and then if they seek the diversity of international bonds they can gain access via Smart Shares for an annual fee of 0.54% p.a. (We’re not of the view that this is necessary either).

Before all the fund managers line up at my door to poke me in the eye, I have a mild plug for them; If you are going to pay a fund manger a fee then demand that they manage risks that you are not willing, or able, to manage yourself.

Accordingly, I support fund managers’ attempts to encourage investors to take more risk in the funds that they select.

A typical young investor would achieve reasonable personal diversity by selecting a high level of investment risk for their Kiwisaver account and then pouring every other spare dollar into debt reduction. Once they repay their debts, they could assemble their own investment portfolio of low risks, such as deposits, bonds and utility shares (with no management fee).

Leave the management of dynamic risks to well qualified people and pay the annual fee but do the rest yourself.

Always try to minimise your annual fee expenses.

Uncertainty – Last week I spoke briefly about the takeover offer for Tilt Renewables and highlighted the difference between assessed value within a spreadsheet and real-world financial decisions involving risk linked to future scenarios.

Last week we saw another helpful example of theoretical value relative to actual market pricing, and changes as probabilities are considered; Tegel (TGH) share price.

When Bounty announced the takeover offer at $1.23 the share price jumped from $0.85 to $1.15 then $1.20. However, as shareholders began to consider the risks of the deal not proceeding (volume or regulatory approval) the share price retreated to $1.13.

After a slow process, the deal was approved by the Overseas Investment Office (OIO) and today the TGH share price is at $1.22. The unconditional deal will now proceed at $1.23.

The point is that there was an 8% swing in value between hoping that the TGH deal would proceed and it being confirmed as proceeding (subject now to payment risk).

If I take readers, and TLT shareholders in particular, back to last week’s comments, the margin between the takeover offer at $2.30 and the bottom end of the valuer’s range ($2.56) is about 10%, or 17% below the middle of the valuation range.

Numerically the TLT market has less confidence than the TGH market had in the likelihood of achieving deal completion.

This opinion can be fed from two perspectives:

TLT shareholders may not accept a price outside the independent valuer’s range ($2.56 - $3.01); and/or

Infratil and Mercury may not increase their offer from the price of $2.30 per share.

In reality the current market share price for TLT reflects a combination of both drivers.

What certainty can a TLT shareholder bring to the decision-making process?

They control whether to sell or not sell.

To not sell is to move on and ignore the pricing debate.

But, to wish to sell is to extend the flow chart of decision making.

At $2.30 they have certainty over the process and the price.

If they decide they would sell but they reject the current offer price they introduce uncertainty whilst hoping for a better outcome. However, carrying any risk introduces the potential for various possible outcomes, not just a better outcome.

Here’s a side story:

Last year Spark offered to takeover TeamTalk at 80 cents per share. The offer was rejected by shareholders. Spark did not increase its offer.

TTK’s share price traded for many months at 90 cents in the belief that better value existed.

Dividends were cancelled in 2017 and have not been reinstated.

TTK share price is back at 82-85 cents as I write.

TTK shareholders may, or may not, have invested TTK proceeds into Spark (SPK) shares (both in the communication sector), but if they had they would have received dividends of about 8.00% per annum and enjoyed a 10% increase in the capital value of their investment.

This SPK performance implies an equivalent share price of $1.02 would be needed from TTK for it to keep up.

Back to Tilt Renewables;

Infratil already controls TLT and together with Mercury (MCY) hold 78.3% of the shares so they dominate the business’s strategy. They can support a TLT strategy that looks likely to demand increased funding, a situation that implies modest or reduced dividends from TLT (Note that the TLT dividend has already been reduced between 2017 and 2018).

My point is that a patient seller of TLT shares should not only be thinking ‘will I receive $2.30 or $2.56 for my shares?’, they should also be thinking ‘how would I feel if the share price recedes to $2.15, my dividends are cut, and the company asks me to invest more capital (Rights issue)?’

What is it one says about a bird in hand?

Post Script: Following my writing of this paragraph Grant Thornton has offered a rebuttal on TLT valuation, at Infratil’s request, displaying reasons why a lower value is equally debatable.

INVESTMENT NEWS

Trade – The US, and President Trump, displayed that trade negotiations need not be played out over years, witnessed by the prompt settlement of a new trade pact between the US and South Korea.

China will be watching very closely, as Trump would want.

Just imagine what it would mean if Trump opened trade negotiations with North Korea.

Don’t lose sight of the ongoing discussions between North and South Korea about the potential for reunification.

Neither leader would need to give up on ego-centric responsibilities at this stage if all they did was open the borders to controlled trade and limited movement with visas.

Kim Jong-Un has the potential to make huge gains for his people if he opens his mind to the trade potential involving South Korea and the US.

If he wishes to leave this earthly place viewed as some immortal saint like others before him he’ll need to do more than he has during his first seven years in power and its possible that Presidents Trump and Moon Jae-in could be the key.

US Fed Funds– The US Federal Reserve did as expected and increased the Fed Funds (overnight) Rate by another 0.25% to now sit in the range of 2.00% - 2.25%.

The ‘news’ was that the Fed has removed the term ‘accommodative’ from the speech notes leading us to believe we are now in the zone they wish us to interpret as neutral monetary policy.

The forecast of intentions for future Fed Funds settings over the next two years covers a range between the current setting and 4.125%, which serves to confirm the logical uncertainty of future economic conditions from this neutral point.

Some of the wording used is typically optimistic about the potential for strong economic conditions, but the fact that long term yields declined a little after the announcement reveals less confidence around the wider market.

A neutral Fed Funds rate of 2.00% - 2.25% is consistent with the widely held views that the decade ahead will yield lower nominal returns (and probably lower real returns) from the interest rate asset class.

Retailing – NZX listed retailers are proving that contrary to popular belief the internet has not removed their sales model. If carefully monitored, it has probably enhanced it.

The likes of Briscoes and Hallensteins have repeatedly displayed that good management, using all channels, will yield success. Kathmandu and The Warehouse also show that resilience counts.

EVER THE OPTIMIST– Customer demand has seen the Hawaiki Submarine Cable service increase its speed by 50%.

It is great news to see demand for this second communication link rising so quickly.

ETO II – Moody’s has re-affirmed the New Zealand government’s credit rating at Aaa (triple A), the strongest available, in a reminder that we enjoy a well governed country with conservative financial settings at a national level.

Now, if we could just get individuals to manage their personal financial circumstances in the same way we’d be deserving of the ‘Switzerland of the Pacific’ label, currently only used in jest.

INVESTMENT OPPORTUNITIES

 

Auckland Airport – AIAL issued its new 6-year bond (2024) last week on Wednesday.

The interest rate was set at 3.51%

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

Infratil – has announced its new bond offer, including terms of 6 years and 10 years (5+5 year periods).

Holders of the maturing Infratil bond (IFT180) will have the opportunity to reinvest in the new offer.

The interest rates have been set at:

6-year term – 4.75%; and

10-year term – 4.85% for the first period of 5 years (then reset for years 5-10).

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

Chris will be in Christchurch on October 9 and 10.

Kevin will be in Ashburton on 31 October.

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


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