Chris Lee & Partners Ltd

Taking Stock 24 June 2021

Warning: This Taking Stock item may make readers feel sick and is almost certain to make readers feel disgusted and deeply cynical about those who manage other people's money.

THE background begins in the 1980s, when the late South Canterbury Finance (SCF) chairman, Allan Hubbard, made a series of purchases of rural land in Ashburton, buying plots, including a fallow orchard, from liquidators/receivers who, typically, sold for a song, motivated by convenience rather than by any desire to maximise returns for the property owners.

As is the case too often today, many receivers were lazy and lacked an incentive to maximise returns.

Hubbard paid about $180,000 for an orchard on the edge of Ashburton's urban area.  He put the certificate of title in a drawer, believing that within a decade or two the land would be needed for housing.  Re-zoned, its value would be in tens of millions, not the relatively piffling sum at which his offer was accepted.

For all his foibles as a moneylender, Hubbard was skilled and prescient with his strategic long-term decisions.

Jump forward two decades.

In 2006, Hubbard's company, SCF, needed new capital to support the ridiculous growth its executive was driving, sadly in unintelligent, non-cashflow lending to property developers, many of whom had dreams of fortunes, but no ability to underwrite their dreams.

Hubbard employed a highly experienced, methodical property consultant (John Coers) to prepare a plan for the land and obtain consents to develop nearly 200 sections on the abandoned orchard.

Within four years Coers had designed an upmarket suburb, had his plans consented, installed services and the first two dozen sections had been sold for around $180,000 per section.

Then came the bomb, SCF collapsing under a raft of brainless lending, its ability to underwrite South Island growth threatened by losses and cash flow problems, exacerbated by the global crisis.

Most unwisely, SCF's Dunedin adviser, Forsyth Barr, installed the fast talking American Sandy Maier Junior as SCF's chief executive.  Maier had never restored a major finance company and was at the tail end of his career, distanced from both capital markets, the public sector, and those in political power.  He was intensely disliked by the remaining people in SCF who did know the market.

He was a liquidator dressed up as a company doctor.

Maier immediately began to strip out and sell good assets for a fraction of their worth, in pursuit of liquidity.

What should have happened was a decision by the politicians and Treasury to bring forward their commitment to pay out SCF's retail investors, providing SCF with the cash flow and time to restore the value of its best assets.  Such a restoration would have amply covered the losses of the loony lending.

The Crown already had assumed responsibility to repay the retail investors and thus had no downside in providing liquidity.

But the executives in the cabinet of Key's sorry government, and those responsible for managing Treasury's liability to the guaranteed investors, failed to connect with SCF's adviser, Forsyth Barr (which was a tadpole with the task of managing a fast-flowing river) and Maier Junior, who might have been a whitebait trying to jump over a hydro plant in that river.

Instead of providing cash and time, the government and the public sector officials allowed Maier Junior to flog off assets for a fraction of their value, in a vain attempt to survive long enough to find a deep-pocketed buyer for SCF, and thus scoop up the life-changing cash bonus that he had negotiated, along with his immense consultancy rate.

Back to the Ashburton sections, known by then as Braebrook.

It had unsold land, some 160 sections, selling for around $160,000-$190,000 per section, in the stressed market of 2010.

Maier Junior wanted cash immediately.  He was formally advised by industry experts that he could within weeks sell Braebrook sections if he dropped the price to $123,000.  He responded by selling some 20 sections at $83,000, so desperate was he for cash flow, and, so unsuccessful was he at explaining to the public sector and Key's cabinet that such discounting was throwing away other people's (tax payers') money.

Within months Maier Junior acknowledged that all his widespread discounting of SCF's assets had not given him the time to restore SCF, or sell it, so in came a most improbable receiver (McGrath Nicol), and Maier Junior retired from his $100,000 per month assignment.  SCF was doomed to the worst possible outcome.

McGrath Nicol, the receivers, arrived with minimal staffing resources and, as events were to reveal, an inane approach to maximising SCF's value.

On DAY ONE (!) of the assignment the head receiver Kerryn Downey signed off on an offer to sell the remaining 140 (approx) sections, most untitled but virtually completed, for an insulting $8,000 plus GST per section. Had this transaction been performed in Russia in the 1990s, most would have simply nodded their heads. In New Zealand, such a deal was inexplicably wasteful. Each section was hocked off for eight thousand dollars. That is not a typing error.

Yet Downey and McGrath Nicol had been instructed by Treasury and Keys' Finance Minister, Bill English, to take many years to maximise value rather than charge in and discount assets belonging to the taxpayers, least of all at ridiculous prices.  We know this because English and Treasury recorded these instructions and spoke publicly of it. Their words are on public display in my book, The Billion Dollar Bonfire.

Many many more examples of incompetent decisions, indeed so stupid as to imply buffoonery, were made, resulting in a rushed liquidation at a time when banks were not lending, when entrepreneurs wanted to buy dollar notes for a few coppers.  The market was highly stressed, the worst possible situation in which to flog off assets.

In just two years, hundreds of millions were bonfired, without any intervention from political or public sector leaders.

Indeed, Key unforgettably and scornfully described a hundred million dollars as ''chump change'' revealing a mindset that in my view made him unfit for leadership roles.

But it was not just his $100 million ''chump change'' that was incinerated.

His Cabinet's decisions indisputably led to more than a billion dollars being tossed into the inferno, the lack of commercial nous failing to understand the need to be patient, just as English had urged.  Whichever solicitors were enabling this were demonstrating their lack of commercial nous, their indifference to public money losses.

By 2020, eight years after McGrath Nicol had been retired from its role, SCF's assets had a value of at least a billion more than the hapless receiver had collected, the idiotic Braebrook decision just one example of the worst receivership I have ever witnessed.

To make matters even more inexplicable, the public paid a record-breaking $54 million for this hopeless two-year receivership.

All of this returned to the front of mind this week when the consultant who designed the new Braebrook suburb was back in Ashburton, and called me, to lament the outcome.

He had just visited the suburb, discovering that the new residential centre was operating as designed, the sections, bar a handful, sold for prices between $200,000 and $400,000 each, the buyer favoured by both Maier Junior and McGrath Nicol having been enriched by some thirty million dollars, at the expense of the taxpayer.

All involved in this insane sale, from Key's cabinet, to Treasury, to Maier Junior, McGrath Nicol, right down to the SCF employee who asked McGrath Nicol to sign the contract, ought to feel an emotion far down on the scale of satisfaction, when they consider their foolish and expensive behaviour.

The property consultant, who had done a most efficient and competent job for Hubbard, had agreed to a payment formula that rewarded him for the ultimate success of his plan. His plan has succeeded spectacularly.

He has not received his bonus and will not.

In effect the bonus was given to the two local buyers of taxpayer-owned land who, quite sensibly and legally, said ''thank you'' and accepted the offer to buy $40 million of beautiful sections in a great mid-Canterbury town at a cost of barely $5 million.

If a film or documentary is ever made of this dark period in New Zealand's commercial history, the Braebrook stupidity might be its focal point.

 _ _ _ _ _ _ _ _ _ _ _ _

STILL continuing is the effort to corner the NZ Rugby Union into allowing to proceed with a daft plan to list NZRU shares on the NZX.

The item last week in Taking Stock referred to the alternative plan, from an American hedge fund, which proposed that it provide a much bigger capital sum in return for an annuity that was based on revenue. I am unsure whether this was gross revenue or nett revenue.

Many responded to this item.

None supported an NZX listing.

One of New Zealand's best financial market analysts emailed me, noting that the details of the American offer had not been released, but that media talk suggested that the offer was based on gross revenue, not nett revenue.

His analysis was that after just three years the annuity would become generous, even if the gross revenue did not rise.  It is fair to speculate that the American fund would not want to share the nett profit, if it had no say in controlling expenses.

I was reminded of this difficulty in investing in organisations which logically focus on its own people, when I read a somewhat goofy media item comparing the published ''profits'' of the country's two investment banks, Craigs and Jarden.

The point I make is that what they publish as ''profit'' or ''nett revenue'' is after deducting the bonuses paid to their staff. Unless we know the bonus deduction, the published nett profit is irrelevant.

If Craigs made nett revenue of $100 million and handed out a million to each of its best 100 staff, it would declare a nett profit of nothing, and pay no company tax.  Would that make Craigs appear unprofitable?  Maybe to a novice commentator who did not seek out relevant details.

Those who have not, and never will, work in capital markets take a risk when they compare ''profits'' without first asking the companies to discuss its definition of nett revenue. Perhaps big companies prefer not to take the calls of the daily news media.

A similar trap ensnared many analysts in the past, when the likes of South Canterbury Finance took into its revenue unpaid ''capitalised'' fees and interest, and then proceeded to use this invisible money to pay bonuses and dividends.

Of course, when it was discovered that the loans would never be repaid, the fees and interest never collected, the SCF balance sheet changed dramatically, and immediately.

It then became apparent that all the bonuses and dividends had effectively been paid out of whatever had previously been shown as capital reserves.  The ''invisible'' fees and interest never morphed into any real income.

Reverse out those premature and injudicious bonuses and dividends and suddenly there was very little capital, or in many cases, finance companies with negative capital funds.

Deduct the undeclared, I would say ''hidden'' bad loans, and suddenly there were hundreds of millions of negative shareholder funds, effectively stolen when bonuses, dividends, and even tax had been prematurely paid out.

How stupid were accounting standards that allowed such dangerous and misleading practices? How did any audit firm ever approve this behaviour?

Were the directors simply incompetent or dishonest?

How come trustee companies appointed people with at best modest clerical skills to oversee these companies, and safeguard investors?

How come the Securities Commission, as regulator, was given such a pitiful government budget that it could afford barely a handful of useful people, and was governed by people of, shall we politely say, irrelevant skill and mild interest in understanding the importance of their role?

Was there any in government who cared about these deficiencies?

A cynic might argue that the politicians and the public sector regarded retail investment money as ''chump change''.

 _ _ _ _ _ _ _ _ _ _ _ _

Johnny Lee writes:

THE last few years have allowed us to observe some marked changes to investor behaviour in New Zealand.

The decline in interest rates, coupled with a flurry of maturing bonds and a dearth of replacement bonds, has seen many investors ''move along the risk continuum'' – assuming greater levels of risk in search of an acceptable return.  This has manifested in investors moving away from term deposits and listed bonds towards greater ownership of listed shares.

This was predicted by none other than Reserve Bank Governor Adrian Orr, who commented in 2019 that investors would need to take a more active approach to investment, outside of low-risk deposits.

New Zealanders have always lagged in this regard.

Direct share ownership is far more common in Australia and the United States, as New Zealanders' well-known preference for real estate investment concentrated investible funds into the property sector.  As successive governments have attempted to drive away the tendency to investment in housing, bonds and shares have been seen as the next natural step along that ''continuum''.

Memories from the 1987 share market crash have not faded, but alternatives to share investment have become increasingly unattractive, forcing investors to dip their toes back into the water.

New as well as returning investors have joined this movement.  Older investors seeking to maintain income, and younger investors seeking to outperform almost negative after-tax returns, have led New Zealanders to the sharemarket in droves.  The enormous growth of Exchange Traded Funds is further evidence of an increased appetite for risk.

The advent of Kiwisaver has aided these endeavours.  The recent move to change the default settings for investors from Conservative to Balanced have further normalised share ownership among New Zealanders.  Savers are now able to see updates on their phones, detailing Kiwisaver balances in real time.  However, the volatility that many experienced investors are accustomed to also proved to be something of a shock to many of these newer investors.

The sharp decline in equity markets in March 2020 will no doubt prove to be an interesting case study for the analysts of tomorrow.  The New Zealand index fell almost 30% in the space of three weeks as early data from Italy and around the globe logically prompted investors to accelerate profit-taking and move towards cash in the face of increased uncertainty.  There was also evidence of Kiwisaver funds shifting to Cash, as investors feared the worst.

In the end, huge amounts of stimulus, in the form of ultra-low interest rates and money printing programmes, pushed global share prices back to new heights.  At some stage, the piper will need to be paid, but for now indebtedness is helping drive asset valuations higher.  New Zealand alone has added tens of billions to this pile.

For now, the shift towards share ownership has been rewarded.  While term deposits continue to offer gross returns barely in excess of 1%, income shares have largely been maintaining dividends, and growth shares continue to perform strongly.

The challenge for investors now is to maintain balance.

New Zealanders are typically well versed in the importance of an ''emergency fund'' to provide liquidity in case the roof begins to leak or the car breaks down.  Those with the benefit of financial advice can create appropriate investment policies to help monitor their asset allocation.

We would urge all investors to periodically review their financial position to ensure it remains fit for purpose.

_ _ _ _ _ _ _ _ _ _ _ _

TRAVEL

Edward will be in Nelson on July 8 and July 9.

Edward will also be in Auckland on 21 July (North Shore), 22 July (Remuera) & 23 July (CBD)

David Colman will be in Palmerston North on 30 June

Johnny will be in Christchurch on 22 July.

If you would like to make an appointment, please contact our office.                            

Chris Lee & Partners Ltd

---

Taking Stock 17 June 2021

Chris Lee writes (as his recuperation progresses well):

 

NEW KiwiSaver investors can relax, putting aside any fears that the default provider Booster is running amok, investing unwisely in an improbable, new, unlisted, and poorly credit-rated company.

It is true that Booster has used a large sum of other people's money to enable various original shareholders in Lifetime Retirement to exit the struggling company that aspires to be a provider of low-yielding and fee-heavy insured annuities.

But Booster investors should take comfort that the small, privately-owned fund manager simply could never use investor money in a manner that the investors would not have authorised.

We all know that it is not possible for Booster to break its own rules.

Just as finance companies in the mid-2000s were compelled to behave in accordance with their trust deed promises, so are fund managers today compelled to adhere to their promises.

Just as there were efficient trustees in the finance company era who diligently authorised and oversaw the terms of a trust deed, and then agreed to constrain any breach of those terms, so, too, do KiwiSaver fund managers squirm under the oversight of statutory supervisors, licensed because of their expertise, just as insolvency practitioners are licensed.

Booster is certain to be permitted to invest in high-risk, unlisted start-ups, and its various KiwiSaver funds – presumably the aggressive funds – must be allowed to put investor money into the Booster fund that manages these high-risk choices.  Booster clearly has great internal expertise with sector-leading analytical skills, to make such unlisted investments.

Indeed, far from being fearful, investors might applaud Booster's decision to top up its 1.5% holding in Lifetime Retirement, paying out other investors to boost the holding to nearer 16% of this company.

Presumably had Booster not provided this liquidity then the Lifetime Retirement shares, from which various shareholders wanted to exit, might have had to find a lower exit price, undermining Booster's 1.6% holding. Booster has thus spent up big to enhance its previously tiny holding.

Protected by a statutory supervisor, ensuring the trust deed-proscribed investment procedures would necessarily be followed stringently, investors are entitled to relax.

This strange, I would say foolish, investment decision has followed a process that is kosher, to use a word the late Allan Hubbard often used.

Whether it is a wise decision will be determined in the future.  The decision may be from the same logic that applied to the decision of NZ Funds Management, with the fund it used to buy Bitcoin, a decision that seems to me to be not unlike the choice four hundred years ago of buying tulip bulbs in Holland.

Bitcoin has risen dramatically and, measured at a point in time, allowed the fund manager with its origins connected to Money Managers (NZ Funds), to report a 120% return on one of its small high-risk funds over that defined period when Bitcoin traded at a price many thousands of multiples greater than its price of just a few years ago.

That Bitcoin has fallen by about half from its earlier highs is relevant only to those who have not cashed up, or more inexplicably, those who bought into the fund when Bitcoin was at its peak.

In both cases – Booster and NZ Funds – the decisions to speculate were authorised, supervised by a level of skill and vigour that investors are accustomed to assessing, and presumably ultimately overseen by the market regulator, the Financial Markets Authority.

Whatever comfort one takes from these protection points should make investors rest easy knowing that what they signed up to when they invested is what is now being delivered to them.

Every investor, of course, would have had expert independent advice and would have read the trust deed before choosing Booster as its KiwiSaver manager, or choosing to invest in the particular fund that Booster has used for this foray into a currently struggling annuity provider.

 _ _ _ _ _ _ _ _ _ _ _ _

AT the risk of being contrary and offending those who make their living by assertive protection of the rights of rugby players, and perhaps offending some respected and some third-tier capital market proponents, may I express the view that an NZX listing of the NZ Rugby Union would signal a new era of madness.

This view may differ from those of my colleagues.  We are all entitled to an opinion.

Here we have a co-operative which in most years makes a loss and, like Fonterra, is committed to serve its primary suppliers (players), trying to raise a few hundred million to preserve its stability, and nurture its grass roots.

It needs this money to subsidise the losses caused by paying players and administration for what used to be voluntary work.

Its costs have and would always far exceed income, without ever-greater broadcasting revenue and generous corporate sponsorship.

Its playing numbers, at adult age, fall every year, though currently the participation loss is hidden by the recent phenomenon of women who choose to indulge in what many regard as brutal sports, like rugby league, rugby, boxing, and cage fighting.  (May my granddaughters be immune to this urge.)

Extremely wealthy Russian moguls, and others absurdly over-endowed with money, buy sports clubs overseas and then grossly overpay for the best players, hoping to feed the moguls' egos by winning titles, despite the pitifully small financial rewards, and to assist clubs to sell merchandise at prices that fans will regard as irrelevantly exorbitant.

So in summary we have a disastrous business model striving to recreate the glories of the past, needing cash to preserve the status quo rather than return to the amateur past.

Along comes a skilled, experienced American fund manager which believes it can find new ways to achieve greater box office revenues.  It offers an enormous lump sum to buy a small share of rugby's future nett profits, which it believes it can increase through its connections and expertise.

The logic of this endeavour is that the fund manager believes it can add enough new revenue, and thus nett profit, to benefit itself from its capital investment.  It had to convince the relatively skilled governors of rugby that its plans were feasible.  It succeeded.  The rugby governors saw potential gains from an expert newcomer, and some life-saving injection of cash.

The NZ Rugby Players Association, which is to investment banking what an oil drum and bamboo stick is to a professional drummer, has engaged with the chairman of a small fund manager/ sharebroker in Dunedin, by any measure a dwarf on an Australasian scale let alone on an international scale, a company which would never claim to have any expertise in growing NZ Rugby's international audience.

Its discussions led to a proposal to sell shares and list the shares, raising nearly $200 million from New Zealand rugby enthusiasts.  If money was the sole objective, perhaps the proposal might be worth considering.  But money and expert input were the two objectives of the NZ Rugby Union.

The new proposal naturally appeals to the fund manager/ broker who would derive multi millions in fees, and to a new share platform, Sharesies, which has 250,000 nouveau investors.  If each of Sharesies investors pledged $800, Sharesies would raise $200 million, a little more than half of what the foreign investor pledges.  Nouveau investors are hardly likely to be selected to contribute to the second objective of growing the box office receipts.

But the shares would then be listed and would probably trade amongst the people who buy the merchandise and proudly claim the title of diehard supporters (but not players) of a sport approaching its twilight years, if one judges by player and crowd numbers.

I accept that my view will not appeal to the players' association, to the small broker touting the scheme, or to diehards, who do not accept the trajectory of participation, crowd numbers, and even television audiences.

If rugby has an outside chance of adapting to the new world it must accept that it needs to find the expertise to access large fee-paying audiences in much bigger parts of the world, like China, Japan, the USA, and even the richer OECD countries.  To do this it needs a motivated partner, with aligned interests.

Its alternative is to revert to amateurism, when club rugby was the hub of communities, when the sport was based on evasion rather than collision, and when schoolboys kept their boots when they left college.  I wish.

Sadly, that sounds far-fetched, a forlorn hat tip to the past.

So the entertainment organisers might be the last hope, if we are to pay players and have them play most weeks of the year.

An NZX listing is a solution covered in tinsel, in my opinion, a daft idea, unlikely ever to provide retail investors with any reward other than the brief glow of ''owning'' the All Blacks.

Disclosure: I write this with some sadness, as a former player, referee, coach, and a current spectator.

 _ _ _ _ _ _ _ _ _ _ _ _

Johnny Lee writes:

CONCERNS regarding inflation are rising globally, as investors ponder the likely trajectory of consumer prices and the response by Reserve Banks to this data.

Conventional wisdom suggests that any response – which often translates to rises in interest rates – will be introduced slowly, allowing any impact to be fully absorbed, while reserving the right to react further if data changes.

Adrian Orr's reign has been marked by his tendency to take long-term positions, making small changes to the OCR and observing long-term impacts without overreacting.  Globally, this has become the norm for Reserve Banks.  Newly introduced tools also allow more flexibility to avoid unintended consequences from such a blunt instrument.

In 2017, the Official Cash Rate was not changed throughout the entire year.  It did not change in 2018.  Two changes (down) were made in 2019, and a single reduction was made in 2020.  We have not yet had any movement in 2021.

Further abroad, the US Federal Funds rate has also been static for some time.  Previous attempts to lift interest rates in the US have been met with a very negative response, prompting immediate reversals to lower levels.  Quantitative Easing has filled the gap, allowing the Federal Reserve to inject temporary liquidity into the market.

However, inflation cannot simply be ignored.  Spiralling increases in the difference between the price of goods and the price of labour causes an array of problems for society, especially for those on fixed incomes.

Some commodity price movements seen this year will be undeniably inflationary.  The oil price has almost doubled in the past six months, and still represents a significant spend for most households.  The wild swings in the price of lumber – which doubled from January to May before crashing over the last month - will produce short-term inflationary pressures in the construction sector.  Food costs are rising, and council rates bills are rising.

The cost of labour, exacerbated by the sudden restrictions on freedom of movement, is rising globally.  Closed borders means that the potential pool of labour is much smaller.  Many industries are now reporting staff shortages.  This issue is particularly pronounced in the hospitality sector, although locally we are also seeing persistent issues around the supply of labour in the primary industries space.

Part of this is being spurred by changing habits in the workforce.  Surveys conducted around the world – predominantly in the US – show work preferences are changing.  With most Americans having spent the past year working remotely, many are now stating a preference to continue this behaviour, a preference particularly pronounced among women.  Some roles are simply unsuited to such preferences, which distorts the labour market further.

Inflation is not the only concern the Reserve Bank must consider, of course.  It is now asked to factor in effect on house prices and employment.  These factors can often pull in opposite directions – reducing interest rates may fuel an increase in house prices, while simultaneously incentivising businesses to hire more staff.  However, these growing mandates for the Reserve Bank have been accompanied by new levers.

Newly announced tools regarding debt to income ratios will allow the Reserve Bank to have more precision in mitigating unintended impacts.  By placing restrictions on the amount people can borrow relative their income, the Reserve Bank can attempt to manipulate the outcome of financial stimulus.

The question facing investors now is whether these pressures will be structural or transitory.  It was always expected that, following a sustained lockdown around the world, consumers would delay spending in the face of rising uncertainty.  With the global rollout of vaccines, confidence is returning and wallets are re-opening.  Some consumer spending – global travel, for instance – has been curbed for the foreseeable future.  These factors will, presumably, be temporary and support the argument that Reserve Banks around the world can afford to be patient.

The counter argument is that this change represents a more structural, sustained shift in consumer prices.

Investors can expect this topic to dominate economic headlines for some time.

_ _ _ _ _ _ _ _ _ _

TRAVEL

Chris now expects to be travelling again in August. He will advise dates when he has clearance.

Edward will be in Napier on 24 June and 25 June and in Nelson on 8 July and 9 July.

Edward will also be in Auckland on 21 July (North Shore), 22 July (Remuera) & 23 July (CBD)

Kevin will be in Christchurch on 6 July.

David Colman will be in Palmerston North on 30 June.

If you would like to make an appointment, please contact our office.

Chris Lee & Partners

---

Taking Stock 10 June, 2021

David Colman writes:

I VERY much like the idea (one of many) espoused by Charlie Munger, Vice Chairman of Berkshire Hathaway, which is to make money from selling things that are good for people.

He is coming from a company owner's point of view but I think investors by extension can see the sentiment above as a call to invest in companies that sell things that are good for people.

In a way, this is the basis of ethical investment and, increasingly, Environmental, Social and Governance (ESG) factors are being used to select investments not just according to financial factors.

ESG funds are receiving the attention of ethical investors but the ethics of executives or the company they control can be very different to others and can also be perceived quite differently by an observer.

This tends to mean ethical investment in company shares or bonds may be different, depending on the nature of the company and the views of the investor.

For example, a company that appears to have had an isolated incident in which one employee of thousands has been treated poorly would not necessarily stop an investor such as a managed fund buying shares in that company. But if that employee was a close relative you would probably feel differently as an individual.

Not everyone will agree that generally non-financial factors such as ESG standards are important in the pursuit of profit and not everyone will agree on what is an acceptable level of harm to the planet, harm to society, or be able to easily measure the quality of a CEO or board of directors.

Ethical investing is a work in progress and involves the best of intentions but is hardly an exact science.

The website for the Global Equities ESG Fund, listed on the NZX, includes a description of one of the benefits of the fund being the screening out of companies that engage in contentious activities including controversial weapons, civilian firearms, nuclear weapons, thermal coal, nuclear power, tobacco, oil sands, and companies that have failed UN Global Compact rulings.

A number of the top 10 companies within the fund may not have been involved in weapons manufacture or the like but many have been at least criticised for other malpractice, such as poor working conditions (Amazon), illegal tracking of internet users (Facebook), poor governance (Tesla), and potentially cancer-causing baby powder (Johnson & Johnson).

Ethical investing particularly using ESG standards may require some compromise, it seems.

Charlie Munger's own Berkshire Hathaway, the multi-national conglomerate headed by well-regarded CEO Warren Buffett, has paid hundreds of millions of dollars in fines for environmental, financial, and other offences since the year 2000, according to The Good Jobs First Corporate Research Project's Violation Tracker which is a database of corporate crime and misconduct in the USA.

The tracker data shows that even with Charlie and Warren's well-respected leadership the company failed to meet certain legal standards.

The tracker also illustrated to me that environmental concerns specifically are very much a financial factor to keep in mind, with environmental related offences being at the top of the penalty values quoted for Berkshire Hathaway and many other firms.

The fossil fuels industry dominates the tracker's 100 most penalised companies list by number of records. Six petrochemical companies (Chevron, Exxon Mobil, Koch Industries, Royal Dutch Shell, Marathon Petroleum and BP) are in the top 10, with BP 10th on the list for number of penalties, but top of the list for the most penalised of the oil majors by value, having total penalties of over US$29 billion.

Banks dominate the list of penalties by value. Eight banks (Bank of America, JPMorgan Chase, Citigroup, Wells Fargo, Deutsche Bank, UBS, Goldman Sachs and Royal Bank of Scotland) are in the top 10, with the next three spots also being banks, mainly due to huge fines paid in the aftermath of the Global Financial Crisis.

BP is the only company that is in both the top 10 by number of records and value of penalties. BP shares are unlikely to be included in an ethical investor's portfolio due to environmental records but wouldn't have been a great investment compared to many anyway.

Environmental catastrophes are not easily forgotten. The Deepwater Horizon oil spill remains a significant dark patch (literally) in BP's oil drilling history.

The BP share price has yet to return to the price seen before the disaster that killed 11 people and devastated the marine environment in the Gulf of Mexico in April 2010.

This is during a time in which the FTSE 100 Index, comprised of the top 100 companies on the London Stock Exchange, has increased by over 23% (the NZX50 has increased by over 250% gross).

A Violation Tracker in New Zealand would be a fantastic resource for investors.

Incidentally, a New Zealand listed company, Sanford, appears on the US Violation Tracker website, having been fined in 2013 for polluting waters near American Samoa.

The same company has been recently penalised with a fine and the paper forfeiture of a vessel, for being guilty of trawling in a prohibited area of seabed near Stewart Island in 2017.

Sanford will likely have to pay a fee in the tens of thousands and submit a form for the return of its vessel, a valuable contributor to its fleet.

Considering if the events above rule Sanford out as an ethical investment on environmental grounds may rely on whether one expects its management and employees to conduct themselves, in future, better than they did in the past, let alone one's views on other company events, fishing in general, or even whether animal protein has a place in human diets.

Establishing if a company is, or will be, ethical is not always easy and can vary depending on the individual's views, but a company can always be ruled out where its status is debatable.

The beauty of investing is that you have the ability to pick and choose and are not forced to invest in any particular company.

In my view, an ethical investor can only do so much and ruling out companies that do not meet ESG or other ethically based standards is at least a start.

It is not always going to be easy to invest with a completely clear conscience but I encourage everyone to give consideration to the impact that the companies in which they own shares and bonds will have on people, the planet, and beyond which ultimately, I hope, will be good for us all.

_ _ _ _ _ _ _ _ _ _

Johnny Lee writes:

THE recent announcement made by the Food and Drug Administration, the US regulator of medications, of the approval of Alzheimer's drug Aducanumab may not have warranted more than a passing thought for many observers.

One of the developers of the treatment, US-listed Biogen, soared in share price by over 50% on the back of the news, despite ongoing questions around the efficacy of the drug.  A number of other companies, touting similar products in the same field, also saw share price jumps the same day.  The approval was granted under the Accelerated Approval Pathway – meaning Biogen must complete another clinical trial to verify its preliminary results.

The treatment is not touted as a cure, but as an effective treatment to slow the development of Alzheimer's Disease.

Some experts believe the drug received accelerated approval due to a lack of alternative treatment options, rather than conclusive proof around efficacy.  Regardless, with six million sufferers in the US alone, and a price tag of $56,000 annually, Biogen temporarily has a captive market, and the share price responded.

The drug made headlines about five years ago as the ''first breakthrough in decades'' for the sixth leading cause of death in the United States among adults.  Inconclusive clinical trials, which the company later argued were conducted incorrectly, muted excitement for the treatment.  However, this week's developments may give hope for many around the world suffering the early symptoms of Alzheimer's, and families of sufferers.

For New Zealand investors in the LIV fund – the Smartshares Healthcare and Innovation Fund – it marked another win.  BIIB – Biogen's stock code – is one of the fund's largest holdings.

The two ''thematic'' funds, LIV and BOT, have now resided on our exchange for two years, and have easily outperformed the New Zealand index in that time.  LIV is up 47% and BOT is up 56%, while the New Zealand gross index is up by about 25% over the same time period.

The healthcare fund invests across a large number of companies in the global healthcare sector.  Dominated by cancer medication developers and researchers, the fund has seen some early success in investing in winners.

It is worth pointing out that the fund does not actually individually select stocks – it simply buys into another fund, which in turn simply follows an index.  In this way, potential investors accept they are investing into a ''theme'' – and that investing in such a way will result in winners and losers.

It is no secret that many companies in this sector fail.  Drugs that show promise in mice may not show the same results in humans.  Better treatments from competitors can be developed.  Medical emergencies, such as COVID, can redirect potential funding elsewhere.

If research is successful, biotechnology and pharmaceutical companies often find themselves with a limited window of opportunity to profit from their research, before patents expire and the metaphorical window closes.  And as Pacific Edge has shown New Zealand investors, cash burn is almost always higher than anticipated.  However, the performance of the LIV fund proves that investing in such a ''theme'' has so far been successful.

The BOT fund – the Automation and Robotics Fund – has seen similar success to LIV over recent months.  Dominated by semiconductor designers and manufacturers, several of its largest holdings are currently subjected to takeover notices from the US technology giants.  Its largest holding, Snap Group (owner of the social media application Snapchat), has more than doubled since the start of the year, after rejecting takeovers from global technology giants.  BOT also has exposure to the likes of Apple and Toyota.

Technology and Healthcare are both sectors benefiting enormously from trends towards Mergers and Acquisitions.

Many larger-scale companies are choosing to grow by acquisition, using their huge cash reserves to simply buy the competition, rather than innovate themselves.  The likes of Apple, Microsoft, Amazon and Google are increasingly resorting to growth by acquisition.  Amazon's recent announcement that it was planning to purchase film-making giant MGM for $8.5 billion was further evidence of this trend.

Neither LIV nor BOT pays dividends.  The investment proposition is to target growing companies in sectors that may continue to outperform.

Investing in these funds also provides diversification, both in terms of geography and industry.  There are very few opportunities to invest in these sectors within New Zealand, which is largely dominated by mature businesses and essential utilities.  Many of our success stories end up seeking a listing on foreign shores, preferring the deeper (and cheaper) pools of capital found in Australia and the United States.

BOT and LIV will continue to invest in winners and losers.  That is simply the nature of investing on such a broad scale.  However, this week's news is positive for the holders of LIV, and if the effectiveness of the treatment is proven, it may deliver some rare positive news for thousands of New Zealanders suffering from the devastating disease.

_ _ _ _ _ _ _ _ _ _ _

TRAVEL

Edward will be in Napier on June 24 and June 25 and in Nelson on July 8 and July 9.

Johnny will be in Christchurch on 17 June. 

David Colman will be in Lower Hutt on 16 June and Palmerston North on 30 June.

If you would like to make an appointment, please contact our office.

Chris Lee & Partners Ltd

---

Taking Stock 3 June, 2021

Johnny Lee writes:

ExxonMobil, the American oil giant, learned a painful lesson this week, as it lost several key board members in a shareholder rebellion against its company strategy.

Once the world's largest listed company, and arguably one of the most powerful corporations on the planet, Exxon’s fall from grace has accelerated in recent years as the issue of climate change took to the fore, and public opinion began pushing politicians worldwide to address the use of Exxon's primary product.

Exxon's share price has been on a downward trend for almost a decade, while the Dow Jones Industrial Average has more than tripled in the same timeframe.  The company has been criticised for being slow to address climate change concerns, especially compared to its peers.

Its competitors have instead been investing in wind and solar projects, although the quantum of investment may feel insufficient to climate change activists.  Many of Exxon's competitors are rebranding from oil and gas to energy.  The recent judgement from a Dutch court, in regards to Shell, has the potential to act as a catalyst for further acceleration on this front.

Hedge fund ''Engine No 1'' led the charge to unseat members of Exxon's board, arguing that the company's strategic plan – investing further to increase its oil output - was short-sighted and would prove to be a poor performer for investors.  Exxon was singled out due to its particularly poor share price performance, as well as the slow pace of its transformation away from fossil fuel production.

The argument has proven persuasive.  While there are those who spend time demanding the company stop drilling because of environmental concerns, this has become an instance where the shareholders – the owners of the company and the group which can actually effect change – are voting this way.  In a uniquely capitalist way, the pursuit of profit has led to these two groups sharing a common goal.

Major shareholders of Exxon, predominantly the Exchange Traded Funds such as Vanguard and Blackrock, were instrumental in winning the vote.  These ETFs have been under pressure from their investors, many of whom are retail ''Mum and Dad'' investors, to act on climate change.  Rhetoric was not being matched with votes.

Many of these ETFs, which are designed to simply mimic an index, do not carry the threat of divestment like an ordinary shareholder.  If you own shares in ABC Limited, and the company decides it wants to begin manufacturing landmines, you can simply choose to sell your shares.  For ETFs, annual votes are among the greatest weapons in their arsenal.

It is worth noting that some ETFs choose not to vote, perhaps believing that passive funds are best served by passively accepting the will of the majority.  In Blackrock's case, it has comprehensive guidelines that publicly dictate how it determines its vote.  This does include ESG (Environmental, Social, Governance) considerations.

That the vote occurred, and then succeeded, is not necessarily the key point to be made when considering this issue.  The bigger picture to consider is the increasing influence of Exchange Traded Funds, the influence of ESG, and the need for businesses to understand the very real risks of ignoring public opinion.

I have written before about the growth being observed in Kiwisaver allocations towards ''Socially Responsible'' funds. Many Kiwisaver investors, particularly newer, younger members, are electing to move their funds out of traditional investments and towards these ''Ethical'' funds.

What makes a fund ''Ethical'' remains somewhat arbitrary.  Oil and gas, as well as munitions and land mines, are firmly on the ''Unethical'' list.  Nuclear power, gambling, adult entertainment and meat production are grey areas, with some funds choosing to exclude these sectors, and others happy to invest in them.

Accreditation providers have spawned to help standardise these inconsistencies, but having some variation and flavour to each of these funds is helpful to give investors choice.  If an investor believes that society is rejecting a particular sector then they can choose to invest in funds that deliberately exclude that sector.

In New Zealand, we have very few companies directly exposed to these sectors.  We have no listed weapons manufacturer, no nuclear power generators and no tobacco growers.  We do have a listed casino operator, and various companies involved in the fossil fuel sector.  We also have lenders to these sectors, by virtue of our listed banks.

These ''Green'' and ''Ethical'' labels carry tangible advantages.  A concrete example of this is the growth seen in ''Green Property Funds''.  Shareholders in Argosy would be aware of the company's push towards its ''Green Bond Framework''.  One advantage of pursuing these objectives is access to this growing pool of capital, which introduces an additional lever for creating price tension for funding, potentially reducing costs.

Societal norms are changing, and as investment behaviour changes with it, funds will no doubt seek to be ahead of this curve.  Funds with significant investments in companies exposed to these social changes are seeking to influence changes to move away from these sectors.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

THE past month has seen a flurry of groups expressing an interest in listing on our exchange.  These have ranged from financially troubled paper mills to financially troubled rugby unions and even financially troubled media outlets.

There may be a common element to observe between these groups.

It would be presumptuous to pass judgment on the viability of these companies listing without first observing a Product Disclosure Statement.  But investors can expect these instances of ''testing the waters'' to increase.  With asset prices at or close to record highs, many businesses are making moves behind closed doors to determine whether this is the right time to exit.  There is no denying that the pool of investible capital is very high, while the rate of return investors are willing to accept has declined.

Many of these potential listings will not come to pass.  Some of them are simply creating price tension and trying to force the hand of a potential buyer.  Some will find themselves disappointed at prices offered and wait in the hope of an improving market.  Some will simply be unsuitable for public ownership, particularly around disclosure requirements.

Ultimately, our capital markets tend to do a good job of sorting the wheat from the chaff, and the likes of Private Equity firms will be reluctant to tell their investors that public markets were unwilling to buy their assets without a steep discount attached.  The Private Equity sector prides itself on investing in undervalued assets, before redesigning them as sought-after businesses with a viable long-term future.

Further abroad, the same dynamic is playing out on a much larger scale.  The first three months of this year saw a huge flurry of companies listing on the US exchanges, many of which managed to capture the public's imagination.  Some saw their share prices double after listing.  Many of these companies are Chinese technology companies, seeking to capitalise on investor enthusiasm for the sector.

In New Zealand, while the market would welcome new listings, investors searching for more than a quick buck would be wise to consider these listings carefully, should they proceed.  This year has been something of a mixed Bag, with some shares climbing upon listing, while others struggled.

Investors searching for companies producing sustainable, long-term returns may need to search beyond the proposed crop.

_ _ _ _ _ _ _ _ _ _

David Colman writes:

 

FOR more than 40 years countries have been slashing corporate tax rates to attract more business to their shores.

US President Joe Biden is trying to end the race to the bottom to make up for the hundreds of billions of dollars of tax revenue that might otherwise have been collected.

He is ambitiously attempting to set a minimum tax rate for Organisation for Economic Co-operation and Development (OECD) countries to help in his efforts to raise the US Federal corporate tax rate from 21% to 28%.

Governments have borrowed trillions since the Covid-19 pandemic began, and desperately require greater tax revenue.

Group of 7 (G7) officials, representing the US, Britain, Canada, France, Germany, Italy and Japan, meet in London on Friday where a proposed minimum corporate tax rate of 15% will be discussed before the G20 (a broader range of countries) looks at the proposal in July.

A minimum 21% tax rate was proposed as recently as April but was seen as unlikely to gain widespread support among members of the 'G' groups and the OECD.

The 2021 OECD corporate tax average is 22.8%, down from an average of 32.5% in 2000 which was already down from over 40% in the 1980s.

The New Zealand company tax rate of 28% and Australian rate of 30% look comparatively high but regional taxation complexities (such as additional state taxes and/or trade taxes) can increase the tax burden on companies in other countries (even with a corporate tax rate of 15% such as in Germany) to similar and sometimes higher overall levels than Australasia.

Ireland is a famous example of having a low corporate tax rate, which at 12.5% is one of the lowest in the world.

Ireland has seen an incredible influx of foreign founded, multi-national corporations set up offices with many concentrated in Dublin's own high-tech ''Silicon Docks''. Silicon Docks is so named as it plays host to numerous companies from Silicon Valley, the metonym for global technology companies from the San Francisco Bay Area.

I do not think it is a coincidence that the trend in lowering corporate tax rates coincides with increased globalisation, greater reliance on the internet and the rise of technology conglomerates such as Facebook, Amazon, Alphabet and Microsoft.

Companies, even operating domestically, do not necessarily have patriotic policies.  Such companies are often poor corporate citizens, giving little back to the jurisdiction they are in.

Multinational conglomerates with no need for patriotism will seek to exploit tax advantages wherever they can be found.  High-level executives have much greater incentive to act in the interests of the company that pays them (gives them money) rather than the countries that tax them (takes that money away).

It would be hard to argue that anything other than tax advantages compels a company such as Google (Alphabet), an internet-based advertising behemoth, to establish an office in Dublin some 8,000kms away from its Googleplex base in Mountainview, California.

Taxes saved by well-resourced accounting departments would not have hindered US employees of tech giants from receiving high salaries.  I saw obvious evidence of this in the amount of Teslas and other brand-new electric vehicles lining Castro Street, a shopping and entertainment area I visited in 2018, not far from the Googleplex, Apple Park, and hundreds of other technology firms.

Sadly, evidence of no salaries and little to no welfare is not far away in San Francisco, where the impoverished cower down alleys and under motorways, the more resourceful in tarpaulin tents, and receive little benefit from a federal and state government seemingly unable to help them.

Fewer taxes collected means governments have less to spend to alleviate, let alone remedy and prevent, the agony of those without pay.

President Biden, Treasury Secretary Janet Yellen, and other supporters of the proposal will not need to convince their political peers that social capital requires real capital.

The OECD is looking to ensure a minimum global tax be imposed on corporate revenue wherever its books are located.

OECD agreement will be a big step and it will be a tough task to convince sovereign states to act in unison if history is any guide.  The multitude of different and changing approaches taken to manage the global Covid-19 pandemic delivered no such cohesion.

Co-operation for the human species, even when faced with a threat to us all, is extraordinarily and detrimentally rare.

The idea that countries like Ireland will agree to a proposal that equates to an erosion of its sovereign rights may remain in the notional realm.

In reality, as seen on Biden's doorstep, many states within the US have varying levels of state taxes, so to expect sovereign nations to adopt a specific global tax target may prove difficult and has few precedents.  A lower proposed minimum is already a significant and costly compromise.

From an investment perspective the minimum tax proposal as it is will have some impact on companies' fortunes, with potential for costs to rise for the international business community with services provided by multinationals widely used here and almost everywhere.

Inflation signals may start to appear if the proposal is embraced unanimously by global leaders and if Biden is able to increase the US Federal Corporate Tax rate as he wishes.

Companies in New Zealand from a taxation standpoint will see little change as our company tax rate is already well above the minimum discussed.  The NZ sharemarket (NZSX) has no companies with the comparable scope and scale of major tech firms.

The total value of companies on the NZSX is approximately NZ$180 billion.

Apple Inc. alone has a market capitalisation of over US$2 trillion with annual revenue of US$260 billion.  If the profits from that kind of revenue can be taxed more it would help fill the OECD countries' cobwebbed coffers.

One of my hopes for the minimum global tax proposal is that any additional tax revenue collected helps close the inequality gap that has grown wider as the well-connected corporate elite have accelerated away from the economically disadvantaged.

_ _ _ _ _ _ _ _ _ _ _ _

TRAVEL 

Edward will be in Auckland on June 9 (Remuera Golf Club) June 10 (NOW FULL) and June 11 (Wairau Park).

He will also be in Napier on June 24 and June 25 and in Nelson on July 8 and July 9.

Johnny will be in Christchurch on 17 June. 

Kevin will be in Timaru on 14 June.

David Colman will be in Lower Hutt on 16 June and Palmerston North on 30 June.

If you would like to make an appointment, please contact our office.

Chris Lee & Partners Ltd

---