Chris Lee & Partners Ltd

Taking Stock 12 December, 2019 

Johnny Lee writes:

2020 is almost upon us, and with the conclusion of another year comes an opportunity to reflect on the past year and prognosticate on the year ahead.

2019 was a year of significant winners and significant losers. Some companies lost due to incompetence, while others lost due to circumstances beyond their control. Some winners simply found good fortune, while others invested wisely and took risks for deserved rewards.

Among the biggest winners would undoubtedly be those investors who chose to migrate from maturing bonds into owning shares. The headline stock exchange index was up about 30%. Kiwisaver investors will have enjoyed a small increase to their balances; especially those tilted more towards growth investments. Similarly, homeowners with a mortgage will undoubtedly be pleased with the direction of interest rates, especially those with terms that allow them to capture the benefit immediately.

For many investors, the move to shares was a forced decision as term deposit rates dried up to undesirable rates of return and the bond market found more money returning than being sought, leading to a compression of rates.

These bond issuers were undoubtedly winners. Bond offers filled, many oversubscribed, at yields that would have seemed laughable twelve months before. Shareholders of Infratil, for example, would have been delighted at its success over the year, securing long-term funding at such historically low levels. Infratil would be churlish not to be celebrating the low cost of debt.

Indeed, Infratil had a transformative year, as it took the reins on one of New Zealand's largest businesses (Vodafone) and looked to divest itself of those assets it saw as underperforming. Its share price is up over 30% for the year, proving that its strategy is adding significant value to shareholders.

Another winner, and one I absolutely did not predict, has been those engaging in crowdfunding to raise capital from the public, especially in the area of marijuana research and development. While my view has not changed, it is undeniable that more and more companies are raising millions of dollars from the public to invest in highly speculative industries and products. My only hope is that investors are continuing to practise due diligence, diversification and a healthy dose of scepticism when considering investing in such companies via such a poorly-regulated platform.

E-Road had a good year, and is finally cashflow positive, reporting a six-figure loss for the first six months of its 2020 financial year. Profitability seems imminent, although its investments into growth will likely require further capital from shareholders. It seems a foregone conclusion that the cost structure of road maintenance will need to change as technology improves and fuel tax becomes a less prolific source of government revenue. E-Road might hope to be at the forefront of this change, although the pace for such change remains something up for debate.

A2 Milk, similarly, had a good year both in terms of results and share price performance. Recent volatility, introduced by the departure of short-term CEO Jayne Hrdlicka, is unlikely to change the long-term trajectory of its performance. The recent share price fall is perhaps evidence that good governance includes succession planning.

Despite the setback with the Tiwai Smelter, investors in energy stocks have seen healthy dividends and strong share price performances this year. Utilities are not normally the most exciting of investments, suiting those interested in income as opposed to international growth. Nevertheless, Meridian's share price has increased more than 40% this year, well exceeding the industry average.

The defensive Listed Property Trust sector also enjoyed outperformance, especially Goodman Property Trust. Demand for long-term property, across all sectors, seems strong, especially in supply-constrained areas such as Wellington, with rents rising and costs falling considerably as interest rates fell. The sector was able to raise fairly cheap equity, using the money to repay debt to banks and thus de-risk. The property companies with high levels of debt will have had a bumper result, but at the cost of risk. Vital Healthcare was one to take that risk, choosing to utilise historically low cost of debt to expand its portfolio.

Hawke's Bay Regional Council deserves a special mention, after finally listing Napier Port on the stock exchange. While most councils are writing to ratepayers advising of an increase in their annual invoice, HBRC recognised the financial costs of fully owning a port and sought an innovative solution from New Zealand's capital markets.

The NZX will be happy with its own performance, with its share price growing nicely as the year progressed. TradeMe left our exchange, while the likes of Napier Port, Cannasouth and the Private Land and Property fund joined the bourse. Metlifecare may be about to enter the departure lounge, although that story may yet have a twist to it. The welcome addition of Sharesies provided an avenue for new investors to engage with capital markets, removing some of the cost barriers associated with trading small amounts of shares, in an ambitious attempt to attract novice investors with just a few dollars to invest. Importantly, this experience for newcomers will have been profitable, a 10-dollar portfolio growing to perhaps $12.

Overall, investors in strong, cash-flow generative shares have had a terrific year, enjoying dividends and capital growth that is among the best in the world. As portfolios have grown, those charged a fee calculated on the gross value of the portfolio would have seen their costs spike, perhaps unjustifiably so. Our preference remains that, where possible, investors should seek to minimise both fees and churn, investing with long-term goals and avoiding short-term panics.

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2019 has also been a year of significant challenge for some.

The losers for the year would undoubtedly include many operating within the construction sector. A large number of firms went broke, while others shrank or found themselves in need of additional capital. During an apparent shortage of houses, while house prices are at record highs, New Zealand still hasn't found a way to adapt its building sector into one able to harness these market forces. Many lay blame at the feet of the tender process associated with building contracts, which incentivise the cutting of both costs and corners. Others might condemn the governance and management in the sector.

Fletcher Building may very well finish the year with a share price slightly above where it started, as it sold out of certain industries and refocussed its strategy. When industries become fractured and stressed, and margins become squeezed, the survivors are usually those with the most capital.

Steel and Tube, by contrast, will finish the year significantly south of where it began. Beleaguered shareholders will be ruing the lost opportunity to accept Fletcher Building’s takeover, and will be either turning their paper losses into real ones, or settling in for the long haul. The stock has been on a downwards trend for almost 14 years, and signs of a turnaround do not seem obvious yet. Consolidation of the sector may be its best chance of survival.

As was the case with Abano, Steel and Tube directors seemed to let their shareholders down by recommending investors decline takeover offers. Accountability for their errors has not occurred.

Sky Network Television's downward trajectory also continued, as it struggled with competition both domestically and abroad. Eye wateringly large sums were spent on sports rights from both sides of the divide, as consumers find themselves torn between multiple providers for different events. The introduction of Disney Plus, a cheap online streaming option featuring most of Disney's impressive catalogue of films and television shows, will put further pressure on Sky TV and its own competing product, Neon. It is clear Sky TV sees rugby as its lifeline.

Pacific Edge, a company everyone would like to succeed, had another awful year in terms of share price performance. Yet another capital raising was announced, this time at only ten cents per share. Importantly, the issue was fully underwritten, meaning that the investment community maintains some confidence in Pacific Edge's future prospects.

Term deposit investors will undoubtedly be facing worsening prospects with bank offerings falling to

levels that barely exceed inflation after tax. The early response to the Reserve Bank's most recent updated capital requirements included a warning that deposit rates may fall in response. However, one wonders whether the banks would be able to meet their required funding obligations if rates drop too much further. This year has seen an enormous number of people disengage from term deposits as an investment option, as they pivot towards shares and other options. The chase for yield is logical but does come with increased risk of capital volatility.

The banks themselves had a year to forget, with major banks facing both legal and regulatory issues, share prices down (at time of writing) and some even reducing dividends. The smaller banks seem relatively immune to these issues, including listed bank Heartland. Heartland is showing no signs of the culture issues seen from others, while maintaining margins in its niche but growing products. Its dividends have grown, its profits have grown, and it has seen a late climb in share price to give it a respectable return for the year of almost 30%, all while paying dividends.

The insurance sector, similarly, will be pleased to see the year behind it, with Government reviews finding the sector, and particularly the culture within the sector, to be lacking. One hopes that it will take the opportunity to reflect and adopt changes to improve its public standing.

The banking, insurance and construction sectors will all be hoping that 2020 will bring an opportunity to put into place new strategies. I would consider all three sectors to be essential to any functional society, and that with the correct settings in place, all three can thrive and produce sustainable and mutually beneficial outcomes.

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2020 will mark an end to much of the uncertainty that plagued 2019, however some uncertainty still remains for investors, while new volatility will be introduced.

A capital gains tax appears to be completely off the table now, with both major political parties pledging not to pursue this option. Investors can assume, in my opinion, that this issue will not re- emerge in the foreseeable future.

Banking capital requirements are now publicly visible, allowing the market to be fully informed and price securities accordingly. The impact has not been fully absorbed but will undoubtedly be negative for homeowners and deposit holders.

Brexit, the topic that will simply not go away, may finally have a resolution soon. One hopes that the conclusion of the election in the United Kingdom will bring with it closure on this issue. For reference, the referendum, in which the public voted to leave the European Union, took place in June 2016.

The commerce commission has finalised its report into competition in the retail fuel sector, predictably producing a set of conclusions that failed to significantly impact the share price of our listed operator (Z Energy). The estimated costs of implementing the suggested changes do not appear to be material, and no update to their financial forecasts seems likely. Motorists continue to pay high fuel taxes, conveniently hidden in petrol pump prices.

The Tiwai closure will see a conclusion early next year. My fervent hope is that the solution produced is long-term in nature, and that all cans are properly disposed of, rather than kicked.

2020 will see an election here and in the United States, both of which are likely to be of relevance to investors for different reasons. Investors should expect volatility around these times, as well as the occasional cry for attention from those struggling to make impact. New Zealander's will be asked to contribute to at least two referenda, one regarding the recreational use of marijuana, and the other in relation to the End of Life Choice Act, important issues to perhaps two different groups of New Zealanders.

Looking ahead, 2020 will hopefully be a year of stabilisation and a slow descent back to normality. Declines in interest rates will likely slow, and with it the outperformance of funds that rely on these mechanics to drive such outperformance. The fantastic performance of share prices should not be expected to continue, and is an outlier when compared to historical performance.

Depending on how the Tiwai issue is resolved, one can expect a spike in volatility once the announcement is made. In the event of a closure, one could expect share prices to fall further, as the sector adjusts to a new environment.

Globally, I expect further moderation when valuing speculative companies. This year has seen some incredible examples of companies, with no history of making a profit and no observable intention to do so, raising tens of billions of dollars from private equity funds and the public. While entrepreneurialism should be celebrated and rewarded, the market is currently in a very excited state, and investors should take care not to allow enthusiasm to override common sense.

Well managed companies, providing essential services and producing sustainable profits and dividends, should continue to flourish, but perhaps not at the outstanding rate we have enjoyed this year.

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To conclude the year I have gathered some data, dated at time of writing that may be of interest to clients and serve to give a sense of how the year progressed.

The Official Cash Rate, or OCR, began the year at 1.75%, and will end at 1%.

The New Zealand main benchmark index, the NZX50G, rose approximately 29% this year. This figure is gross (as opposed to capital) so it includes dividend income.

The Australian benchmark index is up about 20%. The Dow Jones, an American index, is up 18.5%, and the main London stock exchange index is up about 6%. There will be no super over to decide the winner if some index in the globe catches up with New Zealand's pole position.

Including dividends, Fisher and Paykel Healthcare rose 67% this year to be one of the best for the year. Meridian Energy rose 51%, despite its recent dip. Ryman was up 49%, while the Warehouse Group and Goodman Property Trust both climbed 46%. Infratil was up 42%, Mainfreight and Port of Tauranga were up 39%, A2 Milk was up 37% and Heartland saw gains of 30%. Our clients are likely to have enjoyed at least some of those returns.

Those in the middle of the pack include Summerset, E-Road, Genesis Energy, Argosy Property and EBOS, which all grew between 20 and 30 percent, a healthy performance by most measures. Sky City was in this band prior to the awful fire that consumed part of the NZICC, but still closed up for the year.

Those few in the negatives would include Fonterra, down 13%. Steel and Tube ended down 28%, while Pacific Edge and Sky TV were possibly the biggest losers, down 55% each.

Outside of shares, the 10-year Government bond rate, in New Zealand, began the year at approximately 2.38%. It is presently around 1.54%. The US 10-year Treasury rate began the year at about 2.68%, and looks to finish around 1.84%.

Gold rose about 14%, while oil rose about 31%.

Lastly, unemployment has stayed broadly the same, beginning the year at around 4.3%, falling to 3.9%, before heading back up to 4.2% to end the year. This is a key economic indicator, and one we will continue to monitor closely next year. Those choosing to accept large amounts of debt for housing will be relying on their wage income to support these obligations, and a spike in unemployment will create stress for those lending on such assets.

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This will be the last edition of Taking Stock for the year, as our office closes for the Christmas break.

Since I joined our business early in 2019, I have enjoyed and valued the responsibility of contributing to Taking Stock, observing the good, bad and perhaps worse than bad that financial markets sometimes deliver.

I wish you all a safe and enjoyable Christmas period, and look forward to resuming in the New Year.

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Taking Stock 5 December, 2019

 

Chris Lee writes:

IT is a modern trend to scoff at the pre-1985 public sector that decades ago built the country's infrastructure and created our reputation as having one of the least corrupt public sectors in the world.

Those who reformed the public sector in the 1980s were led by some outstanding people like Roger Kerr and Graham Scott, and earlier advocates of reform including Noel Lough.

They advocated that pricing mechanisms led to efficient allocation of resources, enabling economic growth to occur efficiently.

Outstanding public servants like Murray Sherwin had watched the 1970s economic management of the likes of Robert Muldoon, whose autocratic ways paid little heed to expert advice.

Buying into the liberalisation of the NZ economy, Roger Douglas, Richard Prebble and David Caygill oversaw a transformation that might be described as a transition from excessive, arbitrary and often illogical over-regulation to an era of deregulation, almost non-regulation, leading to all those absurd practices that resulted in the 1987 financial market collapse.

To put that into perspective, by 1987 the NZ Stock Exchange had approximately 450 listed companies. Just a few years later, that figure had halved. It is today around 150. Deregulation had led to chaos.

Many who built personal fortunes in that era did so because there were often no rules in such key areas as insider trading or front running.

As a simple example, if Brierley Investments was going to offer $5 a share next week to buy out a company whose shares were at $4, there was nothing to stop Brierley's directors telling their mates, and nothing to stop Brierley’s directors instructing their personal superannuation manager to buy as many as possible at $4. The insiders could fill their pockets. The law said so.

In the 1980s, the public sector had either abandoned the concept of sensible regulations or failed to convince the politicians in charge to install such controls during the process of liberalisation.

At the same time, the public sector was changing dramatically, with government departments being rebranded as state-owned enterprises given financial rather than social objectives and seeking out ''chief executives'' with private sector-like remuneration for short-term contracts.

New Zealand in full sprint converted from a perhaps stodgy public service to a fleet-footed new model, attracting people with financial objectives.

Experience and knowledge were often discarded, as highly-paid chief executives with short-term objectives were given the reins, reporting to politically appointed boards, with little or no heed paid to governance experience, relevance and talent. Given the generally poor performance of politicians in governance, what chance did the SOEs have with ''directors'' chosen by politicians?

In the minds of the agents for change, NZ had to get rid of the likes of tariffs, reserve asset ratios, subsidies and over-engineered infrastructural projects.

In the terminology of the day, all the cardigans and short pants had to be replaced by three-piece suits (worn by either gender).

My uncle had much earlier headed the Government Stores Board, a government department which bought all supplies, from cars and trucks to typewriters and blotting paper.

He would delight in his successes in negotiating discounts and accessing functional but cheaper supplies. He was never highly paid.

His reaction to the changes was of horror, as would have been that of my grandfather, who was the ''secretary manager'' (chief executive) of the Wairarapa Hospital in Masterton.

They had represented an era when long service, knowledge and experience were prioritised.

The new initiatives mocked the old standards, promising improved services, based on the concept that the market would vote with its wallet, ensuring Crown services were focused on optimal outcomes.

Doubtless NZ needed to leave behind Muldoon's cantankerous and often ignorant ''I know best'' approach.

But has it worked out as planned?

Has the new culture of short-termism produced an unintended consequence of the reforms?

Recent figures released by Treasury suggest there have been disastrous consequences.

Staff turnover, especially at executive level, has been extraordinary, exceeding 25% per annum in Treasury. Twenty-five per cent! Continuity? Experience?

New and inexperienced ministers like Robertson have been tasked with learning a job without anywhere near the input from Treasury that, say, Douglas had in the 1980s.

The story may be apocryphal but it is alleged that Treasury's criteria to select executives has now resulted in an alarming shortage of economists with analytical skills.

The criteria to be used have been set to avoid any unintended bias on the basis of gender, race and maybe universities, Waikato, for example, seen as a much lesser university that Auckland. To prevent bias these sort of details are deleted from applications.

Old timers look at the government departments of today and opine that highly-paid, short-term contracts might help people to put a sheen on the curriculum vitae but do nothing to safeguard the quality of advice being offered.

When Bill English was Minister of Finance, he spoke the language of his mandarins but one could hardly expect the likes of Robertson, after a career in foreign affairs, to integrate political agendas with public sector-speak and advice.

Indeed, Robertson briefly talked of changing the culture of Treasury. His talk has remained unsubstantiated by action to date. Perhaps the change is to arrive next year.

The reforms of the 1980s have undoubtedly removed some inefficiencies but the unintended cost seems to have been a focus on the short-term, a loss of skilled experienced advisers, high staff turnover and a great number of poor decisions.

The Reserve Bank, independent of political interference, seems to have been an exception. We will all watch the Reserve Bank's new approach to its supervision of banks, insurance companies and finance companies, with an expectation that the errors of the past two decades will not be repeated. A great deal rests on Adrian Orr's agenda, which will again be in the spotlight today, as he reasserts the changes he wants in our major banks.

One old-timer told me that the awful Ministry of Business, Innovation and Employment (MBIE) was nowhere near the worst of the public service departments, certainly less corroded than Treasury. If other departments are worse, we need serious surgery. Investors need to ponder what this means.

Perhaps none of this would matter as much if our Higher Salaries Commission, chaired by a former politician (of course), had not converted the concept of attracting politicians with ''a mission'' into attracting those to whom a life-changing salary is a goal of its own.

When Maggie Barry announced she would retire after nine years of ''fun'' in Parliament, some of those years as a Cabinet Minister, she retired having been paid in those nine years around $1.5 million and looking forward to a lifetime pension of around $60,000 per annum after tax, if my calculation is right. Nine years in Parliament is the minimum stint to pension entitlement.

Many politicians retire after nine years, Nathan Guy being another example.

A lifetime pension of $60,000 after tax probably has a capital value of around $1.5 million, at Barry's age.

Barry, previously a gardening journalist, had been remunerated at a level one might expect if one were a highly successful business executive with a great deal of expertise.

I pick on her example solely as her nine-year stint and salary have been widely observed.

What is now visible is the change in the type of people attracted to politics, given that the remuneration is so generous.

Our Prime Minister is paid more than the PM of Britain and is the seventh highest paid Prime Minister in the world, according to Purdue University research.

Go back 45 years and you had Muldoon as Prime Minister, earning a little less than $14,000 per year, when third-year schoolteachers earned $3,500 per year, a quarter of Muldoon's salary. What would that ratio be today?

If we are to have people aspiring to be on the ''list'' to enter Parliament on salaries that might be described as their ''main chance'', and to be advised by executives with short-term contracts, how are we going to get wise long-term decisions?

Is it not obvious that we will get tourism ministers who prioritise more tourists next year rather than seek to build infrastructure to ensure we have repeat tourists forever?

Wire barriers down our highways bring in no short-term revenue but they save the lives of those who might not be accustomed to driving on the left.

Would a slick short-term tourism minister have budgeted for highway barriers or promotional advertisements?

Would a government departmental head on a huge short-term contract, with bonuses based on revenue, advise the minister to choose the barrier or the promotion?

I use that as a fictitious example of the difference in wisdom between short-termism and those with long-term objectives.

If our public service sector really is filling its boots with the rewards of short-termism, and if the substance of our politicians is changing, we are watching a category 10 storm heading our way.

Investors need to link this with the highly sensitive issue of business confidence and should be reading carefully any changes in how our country is viewed in matters like corruption.

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ONE simple explanation for the lack of effective scrutiny of politicians in the last decade is the smokescreen our political parties can now raise by accessing the media to manipulate public opinion.

Major political parties now habitually engage social media manipulators to fill social media with faux information, phony opinions and saturation of kind comments, whenever a politician is under pressure.

Stuff articles allow anonymous comment that is no longer treated like a letter to the editor, which would be verified before publishing. Anonymous drivel sets the tone, often initiated by political parties.

Using pseudonyms, a political party might bombard the comments section with lies, without any accountability, distorting the apparent public response, exploiting those who are not familiar with the strategy.

The thought of the government owning our major media channels is itself frightening, especially for investors, who rely on the facts being presented transparently and expect accountability to control behaviour.

As we saw when the truth emerged after the South Canterbury Finance debacle, the government and the public sector is easily able to avoid accountability, and can manipulate the public through social media, allowing weak ministers to avoid scrutiny.

This is tiresome in itself but Crown control of the major players in television and radio would allow even more deception.

Do we need an expanded Ombudsman's office to reinstate accountability?

Do we need a media Ombudsman to prevent all the faux commentators?

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Jonny Lee writes:

Shareholders of New Zealand's listed electricity companies will be patiently waiting for the conclusion of Rio Tinto's review into the Tiwai Point aluminium smelter, expected in February or March of next year.

A further twist in the story occurred this week, with both Contact Energy and Meridian Energy announcing they were each contributing $5 million towards fast-tracking an upgrade to some of Transpower's transmission lines in the South Island, allowing them to better handle any excess supply caused by a closure of the smelter.

This seems prudent and, more importantly, will shift some of the bargaining power away from Rio Tinto.  Part of its bargaining power was its position as the sole buyer of such a volume of electricity, and that the smelter's closure would result in an unusable excess of electricity.

Rio Tinto still maintains a strong position for bargaining. A closure would impact hundreds of jobs and multiple industries, as well as disincentivising any new projects to increase New Zealand's electricity production.  It would impact share prices, devaluing Kiwisaver accounts across the country, as well as reducing Government revenue as the majority shareholder of several major power companies.

It would be premature to suggest that Contact and Meridian's actions foretell a closure of the plant. In its announcement to the stock exchange, Contact Energy made it very clear that a closure was not in its best interests, and would be a very poor outcome for the country.

The announcement should give shareholders confidence that their respective boards are considering all options, and ensuring the market is well placed to handle whichever outcome is decided.

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IN what is shaping up as the worst year in recent history for the banking sector, Westpac now faces its worst month yet, as shareholders and regulators line up to engage in action against it.

Westpac was found to have breached its anti-money laundering obligations across more than 23,000,000 transactions, barely a year after the conclusion of the Hayne Royal Commission.

The timing could not have been worse, with the regulator announcing its conclusions in the middle of Westpac raising $2.5 billion in additional capital.  The retail investors taking part in this capital raising, amounting to $500 million, were given the option to withdraw their offer.  Given the recent share price performance, I imagine many chose to accept this option.

The size of the fine is, at this stage, unknown.  News media are reporting it may eclipse Commonwealth Bank of Australia's fine of $700 million.  A fine of a billion would represent 40% of its recent capital raising and less than half of a single dividend payment. It is not inconsequential, but it will not bankrupt the bank.  Ultimately, the shareholders will pay the cost of Westpac's gaps in process.

Long term, the reputational damage caused is likely to be more relevant.

Westpac also faces the potential of further legal action, as questions are asked over its adherence to continual disclosure obligations.

This would be a complex issue to resolve.  It is undoubtedly true that Westpac, internally, was aware of the magnitude of the problem it faced well before the announcement to market.  It is also true that the public announcement caused a large fall in share price value.  Were the buyers in the lead-up to the announcement fully informed?  Should the stock have been trading when Westpac was aware of an imminent announcement, likely to send the share price tumbling?

2019 has not been a kind year to many of New Zealand's financial institutions, with the insurance sector facing reform, and the banking sector under increasing regulatory scrutiny.  Many will be looking forward to a Christmas break, and a renewed focus for 2020.

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THE Reserve Bank has delivered its final decision on the updated bank capital requirements today.  At first glance, the Reserve Bank seems to have largely stuck to its guns, conceding mostly in the timeframe for implementation, from five years to seven years.

The initial share price reaction was muted, with Heartland responding quickly to comment that the revised Framework will not cause Heartland ''to change its approach to dividends or to raise equity from shareholders''.

Kevin will expand further on this topic in Monday's Market News.

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TRAVEL

Edward will be in Wellington on 12 December.

Chris Lee

Managing Director

Chris Lee & Partners Ltd

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