Chris Lee & Partners Ltd

Taking Stock 24 September, 2020

Johnny Lee writes:

HEARTLAND Bank has reported its Full Year results to market, a month later than usual, ending speculation as to how the company has fared during what has clearly been a challenging environment for all. The share price, which had fallen in the lead up to the announcement, saw an immediate bounce. The period covered by the results was for the year ended June 30th – an important point considering subsequent developments.

Headline profit was slightly down, bad debt provisioning has risen, and the dividend has been temporarily reduced due to the restrictions applied by the Reserve Bank of New Zealand (RBNZ). The dividend of 2.5 cents per share will be paid on the 9th of October. The dividend was able to be paid due to the diverse geographic nature of the group, which includes the Reverse Mortgage business in Australia.

Fortunately, the rest of the news was more positive.

Heartland is forecasting a return to growth next year, barring any further adverse conditions. It also expects dividends to resume closer to previous levels following the easing of restrictions from the RBNZ, although there was no indication of the timeframe around this. One imagines the RBNZ will be conservative in its approach. Earnings per share actually rose 5%.

One example of the nimbleness afforded to smaller banks was Heartland's ability to connect with its customers very rapidly as the Covid crisis unfolded, reaching out to its customers to provide support and better understand their needs. A significant proportion accepted this support, but Heartland is already seeing some return to pre-Covid levels in repayments.

Heartland also noted that the increase in mortgage deferrals seen this year has led to some people choosing to increase repayments on costlier interest-bearing debt, such as consumer lending. Mortgage deferrals allow banks to effectively extend loan durations, yet paradoxically are perceived as ''generous'' on the part of banks. The winner from these longer-dated loans will be the bank, not the borrower.

Costs at Heartland have risen yet again, driven primarily by an increase in staff numbers and budgeted marketing expenditure. This marketing expense will largely be directed at increasing awareness of its Reverse Mortgage business. In New Zealand, Heartland is the overwhelming market leader in this product, albeit a large fish in a small pond.

Cost control will be aided by the push to digitise its offering, with usage of the Heartland ''app'' continuing to grow.

Across the Tasman Sea the Reverse Mortgage business, while not necessarily ''recession proof'', continues to surge. Reverse Mortgage lending, where cashflow is lent against an existing asset, is facing far less competition than traditional banking products, and faces a different set of risks.  Reverse Mortgage lending does not require employment – in fact, it is normally utilised by people without employment income – but it does require relatively stable asset prices. With interest rates continuing to fall, demand for Reverse Mortgages appears to be climbing, as the group of people with large assets but falling incomes continues to grow.

The other divisions within the bank were a mixed bag, with business lending continuing to perform, while livestock was adversely impacted by drought and motor vehicle finance struggled in the lockdown environment. Heartland is confident both factors are temporary in nature.

Multiple disclosures over the previous six months revealed that senior management had been buying shares in the company during the earlier lull in the share price. This was all appropriately disclosed and is not unusual – most investors would be pleased that those within the company wanted to own more shares – and clearly, those buying viewed the shares as undervalued.

The amount of Government support for this sector should not be underestimated. The Wage Subsidy Scheme, the Business Finance Guarantee Scheme and the proposed depositor protection scheme have all helped shape this result and the subsequent path forward.

As Heartland notes, its exposure to the tourism, hospitality and retail sectors is immaterial. The leap in unemployment among young people has yet to cause any undue impact on the bank.

The finance sector is one that is particularly exposed to increases in unemployment and decreases to economic activity. Heartland is not immune to this – but it has positioned itself as a niche bank with products that face a set of risks that have not yet felt the same degree of adversity as the other banks.

Kevin Gloag will be updating our research article on the Private Client Page shortly.

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IN TWENTY YEAR'S TIME, when the next generation of economists and market participants look back on this era during their university studies, one question that will almost certainly go through their minds will be ''What were they thinking?''.

With interest rates at such low levels, there is a very obvious movement from investors and savers along the risk continuum from bonds and term deposits, to the sharemarket.

The last five years has seen tremendous growth in share prices, with the S&P 500 up almost 75% in that time frame. Technology shares have been the core driver of this growth, particularly the largest technology companies, which have used their market power and access to seemingly limitless capital to reduce competition by acquisition. This has led to enormous increases in wealth for long-term shareholders. The proverbial monkey throwing darts has now made such profits it can buy as many bananas as it wishes.

Ten years ago, the largest listed companies in the world were almost exclusively petroleum companies – Exxon, PetroChina, PetroBras and Shell. Now, Apple, Microsoft, Alphabet, Amazon and Facebook dominate this metric.

Ten years ago, the largest automobile companies in the world, by market valuation, were Toyota, Volkswagen, Honda and Daimler. Today, Tesla outvalues all of those companies – combined.

However, signs are emerging that some of these valuations are prompting poor corporate behaviour, as new companies desperately try to take advantage of sky-high valuations.

The story of Nikola Corporation, an American-based company that purports to design and one day build hydrogen powered cars, is one such example.

Nikola listed only a few months ago, following the acquisition of an existing listed company. Within a week, the shares had doubled, valuing the company at $30 billion USD – about a third of the entire New Zealand stock exchange. Its chairman and one of its largest shareholders, in between spending hours on Twitter engaging with the public, announced plans to begin construction of hydrogen-powered trucks in 2020.

Corporate filings revealed the company had virtually no revenue throughout the year – beyond installing solar panels for its chairman – but shared a video of a seemingly functional prototype, boasted of its innovative internal designs and even saw motor vehicle giant General Motors acquire a large stake in the company, valued in the billions.

However, the share price has tumbled following revelations from research house Hindenburg Research, which claims Nikola, and its technology, is a fraud. It claims the prototype vehicle was simply rolling down a hill. The in-house proprietary components were purchased from existing manufacturers and had masking tape to hide logos identifying their origin. The General Motors deal, initially believed to be a sign of confidence in the company, was horribly one-sided to the benefit of GM. The ''billion dollar deal'' involved no actual payment of cash – just assurances around supply chains and technology sharing.

The company is now being investigated by the regulator. General Motors, seeing its own share price fall 10% in the aftermath, is defending itself from accusations that it failed to conduct proper due diligence. The Nikola chairman, after initially stating that he would rebut the claims made against his company, instead resigned, leaving him with little more than $3.1 billion worth of stock to his name. Shareholders, excited at the idea of a taking part in a new company of the future, are left with a share price heading downhill, and a product that only functions downhill.

''The next Tesla'', as it had been described, had seen a huge increase in interest from both retail and institutional share traders, no doubt including the various ''passive'' index funds. The tie up with a major, well-known competitor lent credibility that the product was real. It may one day be. But valuing a company at more than $30 billion, with revenues less than an average American coffee shop, was stretching that credibility.

Investing for future earnings is not in itself unusual. Speculating that a company's product will be successful and produce a profit is different from punts on unproven technology and an unseen product.

Any experienced investor knows that the proposition ''shares only ever go up'' is nonsense. Share prices are a function of supply and demand, themselves a function of thousands of individual factors.

Two of the hardest things to face as a share investor are selling a share at a loss and buying a share after the price has already taken off. But while waiting for a company to prove itself may forego the biggest potential gains, the shareholder who purchased Xero shares at $25 would still have quadrupled their money.

If, one day, we are to decrease our reliance on fossil fuels, innovation in our transport sector, indeed our technology sector, will play a huge role. The world wants this technology to succeed. But as investors, we must ensure valuations are borne of real revenue, real products and real profit.

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EROAD's CAPITAL RAISING of $50 million is now open, with $42 million already completed courtesy of a placement at $3.90 per share. The much smaller balance of $8 million will be available for retail shareholders. The shares will be priced at a maximum of $3.90.

Shareholders have been given nine days to respond to this offer. The steep discount is likely to attract some interest and given the roughly 50% gain in share price over the last three months, shareholders will likely be feeling positively towards the company. I expect scaling to reflect this.

The capital raised will be used to accelerate growth, both in terms of development and marketing. The current focus in terms of growth is Australia, where EROAD is making a renewed push to break into the market.

Earnings guidance was also provided in the accompanying presentation. EROAD has seen continued growth in all major markets and is forecasting this to continue. Retention rates – customers continuing to use its products long term – remain high. Ultimately, its success will be tied to its ability to find new customers and innovate new products to add more value to its proposition.

An article is available to view on our website for advisory clients only.

Clients wanting to discuss the capital raising are welcome to contact us. The offer closes next Friday.

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LAST WEEK'S GDP NUMBERS, showing the largest quarterly fall since records began, were entirely expected.

No one reading this would be surprised to learn that the June quarter was a huge challenge for virtually every sector – with the brunt of the decline seen by sectors including accommodation, tourism and retail. Construction also saw a large decline. The one sector that saw growth in the quarter was the Finance and Insurance sector – also not unexpected as people took steps to organise their financial affairs moving forward in an uncertain environment.

Spending plummeted, especially on transport, recreation, and restaurants and hotels. Lockdowns have this effect.

The value in this data is to measure the degree of these declines, and to measure their duration. Are we to see a short, sharp shock, before climbing back to historical levels, or a long, enduring slowdown?

Treasury estimates, courtesy of the pre-election fiscal update, were forecasting the latter. They made for sobering reading. Unemployment is to rise until 2022 before beginning the journey back towards the low levels we have enjoyed in recent history. Government debt will continue to climb for the foreseeable future. However, this is a highly uncertain situation. Already, we are seeing renewed Covid outbreaks throughout Europe as countries consider reinstituting lockdowns.

New Zealand, whether through luck or design, has fared remarkably well relative to our peers. Unfortunately, we rely on those peers to purchase our exports, stay at our motels and add to our GST take while touring our country. We will need to be patient, as the recovery from the health pandemic seems to be elusive.

These are unprecedented times and uncertainty reigns. The best companies are preparing their business models to cope with further outbreaks and further lockdowns, and making the structural changes needed to survive in this environment.

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TRAVEL 

David Colman will be in Lower Hutt on Wednesday 7 October.

Johnny will be in Christchurch on Wednesday 7 October.

Kevin will be in Christchurch on Wednesday 21 October.

We have now planned our final three seminars, entitled No Hiding From Risk.

Tauranga – September 29 – 11:30am - Tauranga Yacht Club

No restriction on numbers.

Please note: Due to restrictions on groups over 100 in Auckland, we cannot admit anyone who has not re-registered for our Takapuna or Mt Wellington seminars. Please do not assume that your previous registration has carried over.

Auckland – October 5 – 11am - Mt Richmond Conference Centre

North Shore – October 6 – 11am - Fairways Event Centre, Takapuna

Chris is available for client meetings after each seminar. Please contact our office to arrange a time.

Chris Lee and Partners

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Taking Stock 17 September 2020

The Australian Stock Exchange this week was formally advised of a tiny transaction that will have meant rather more for a small number of New Zealanders than it meant for Australians.

Announced was the sort of deal that highlights the risks but potential returns of those who drift into gold mining investment.

There are essentially three types of gold investors, being those who buy physical gold, those who buy shares in proven gold producers and those who finance gold exploration, the latter a speculative activity.

The group who fund exploration will likely have had a record of failed ventures, but when exploration turns into a rare genuine discovery, in turn converting to producing gold at a lower price than it sales value, then punters receive a rich reward.

Historically, such punters often multiplied their investment by 10 to 20 times.

This week the tiny Australian gold explorer Santana triumphantly announced a conditional agreement to buy a tenement in Central Otago, settling the deal with an issue of A$7.5million worth of Santana shares, a promise to pigeon-hole A$3million for further drilling of the Central Otago area and a signed agreement to pay a 1.5% royalty to the original investors in perpetuity.

The condition is that Santana and its Australian broker must raise A$7.5m through an issue of 37.5 million, A20 cent shares to eligible, wealthy Australian investors. It seems that issue has already been booked.

The recapitalised company would then double its board by appointing to the board of directors the two NZ geologists who have been drilling the tenement and whose results have so far indicated a find of around 250,000 ounces.

Santana would then consolidate its previously issued shares on the basis of 70 old for 1 new.

To date the geologists have had the money to drill what in effect is just a one-acre paddock of a 10,000 acre farm.

The geologists seek to keep drilling to prove a resource of at least a million ounces, as well as proving that the rock being drilled has been, in geological terms, recently exposed to oxygen, and thus will release its gold with the cheaper process of heap leaching, rather than expensive grinding of the rock.

Their early conclusion is that the cost of producing gold would leave an impressive margin, if gold prices were to remain around current levels, costs per ounce barely a third of the current gold price, because of the lower-cost extraction process.

There are many ''ifs'', the biggest being the existence of more gold to discover, the price of gold, and the willingness of a future government to allow mining as an activity that creates wealth and jobs, but offends those who oppose all mining.

If the mine proceeds in coming years, it would produce impressive margins and handsome dividends, while creating hundreds of jobs, paying royalties and tax to a NZ government that might be anxious to reduce unemployment and increase its tax revenue to service its alarming level of debt, now forecast to keep growing for at least a decade.

Of course we cannot ban mining if we want the ability to power a transport system less dependent on fossil fuel, rare minerals essential to this process.

The need to tolerate mining was recognised by the politicians when they permitted Oceania Gold to expand its operations beside the excellent Bay of Plenty town of Waihi, and when the Macraes mine in central Otago was further extended.

Indeed the geologist, whose patient work in Central Otago led to the Macraes project, is a part of the team exploring the new project, some 90 kilometres away from Macraes site.

Macraes was formed to mine a million ounce find. The figure of a million ounces has long been surpassed, five million ounces already mined, and a further three million ounces now being mined, the area yielding far more gold than anticipated.

To put that into perspective a million ounces has a gross value today of $2.875 billion and at today's prices would generate a margin of more than half of that, in the new project Santana has bought.

Right now, the gold prices are favouring producers, making it easy to attract investors.

The shareholders of the new Central Otago project, which include some clients (and me, a modest 3% shareholder) will be hoping that over the next three years the geologists will confirm the wider existence of discoverable and extractible gold, that resource consent is granted, and that New Zealand establishes a long-term business venture that does not offend the nation. If all of these conditions are fulfilled with gold prices at handsome levels Santana would have ''stolen'' this project.

Santana will be hoping that the New Zealand project provides a perennially hopeful junior explorer, with a company changing venture.

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New Zealand will lose one of is best public service people when in February next year Murray Sherwin retires.

Sherwin is the chairman of the NZ Productivity Commission, an agency which serves government by employing highly competent people from a range of sectors and professions who investigate issues, including those raised by whoever is the Minister of Finance, currently a former public servant, Grant Robertson.

The public will rarely be aware of the commission's work.

The subjects of its research seldom have the colour to make the front pages of our remaining newspapers.

Not everyone wants to understand why our leading organisations are so slow to grow, why our governance track record is stuck in the paradigm of previous decades, or why our public sector is so fixated with intra-office politics and short-term objectives.

Sherwin is rare in that he has served with distinction at a very senior level in a number of Crown entities, including the Reserve Bank, and has been a key member of various think tanks, serving Prime Ministers as varied as the autocratic and ultimately alcohol-affected Rob Muldoon, and the eloquent dilettante, David Lange.

Sherwin would have regularly interacted with senior politicians and civil servants in Australia, as well as here, solving problems and providing independent analysis and judgement.

But his principal asset would have been his ability to form meaningful networks in the private sector, not just with the self-serving ''Big Four'' accounting firms but also with those rare leaders whose intellect and drive create wealth and jobs for New Zealand.

The NZ Productivity Commission's latest published work, of which I am aware, examined the standard of governance and leadership in our major companies and institutions.

Their conclusions will have been couched politely so I will paraphrase what I expect they wanted to say.

Our governance is characterised by:

1. Inertia, caused by excessive weighting of decisions in deference to the self-serving lawyers and accountants who dominate boards, usually without insight.

2. Market disconnect, caused by the absence at board level of our best leaders.

3. Fear, caused by an inexplicable reluctance to measure return and risk accurately, an inability to think strategically and a reluctance to be judged over the long term. Fear is also caused by accountability, a sad outcome of zealous compliance rules.

Respect for ''political correctness'', obsession with compliance, and a predilection to focus on the short term are all visible characteristics of our governance and our government, polls often driving decisions, as it did alarmingly during the appalling Key era.

Those who break the mould, as Leonie Guiney did with Fonterra's gormless board some years ago, are vilified, even threatened with legal suits.

As an aside, few have the fortitude she displayed in being thrown off the Fonterra board, standing again, being voted back on, and then carving a niche as a great contributor, while the grey, white and mediocre brigade shuffle away.

I particularly admire the attitude of Mainfreight, which has assembled a group of directors that the chairman of some decades can work with, enabling the company to make patient, strategic decisions built around a culture that breeds loyalty and certainty, its projects based on deep market experience and knowledge.

Fisher and Paykel Healthcare may be in that same honorable category.

How Fletcher Building, Fonterra or the ANZ Bank would be lifted were those organisations ever to find aspirational, strategic, intelligent and social leaders to support a 'well-chosen' Chief Executive.

Amongst my most admired New Zealanders are a QC, a liquidator and a now-expired banker, but those groups of professionals are grossly over-represented in our moribund governance.

Lawyers are rarely business leaders or even businesspeople. Often, their connect with the real world is, at best, fractured. Verbosity and loudness do not equate with wisdom.

They are trained to take command of discussions, deflecting business issues to matters of law, and then dominating discussions by quoting law, perhaps interpreting law, and often disingenuously pretending to have the ability to speak as a judge on matters of law.

My experience is that the best boards engage with lawyers on a consulting basis, when required , but focus their decision-making on market knowledge, risk and return, and on their clients, their staff and their stakeholders, without the help of professional people whose experience is narrow.

Much of South Canterbury Finance's board errors stemmed from the reliance on a self-focussed lawyer, serving on a board empowered by its chairman to dictate strategy, often usurping the executive roles. When SCF eventually collapsed, its chairman, Allan Hubbard, saw with clarity how much he had erred. The lawyer on his board had virtually no value-add to a board that eventually became dysfunctional, controlled by the self-focussed.

The NZ Productivity Commission will have assembled enough diverse, smart people, under Sherwin's leadership, to examine these sort of issues.

New Zealand will owe Sherwin a standing ovation when he elects to retire, next year.

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One of our most eminent chairmen once defined for me what qualities he expected to see in a candidate for corporate leadership roles.

In his words the qualities were candour, vigour and rigour, combined with a demonstrable ability to join dots quickly and accurately.

In simple words, he wanted evidence of personal honesty, a commitment to transparency, energy, thoroughness, sharp intellect, good judgement and genuine knowledge.

He added that a great leader must attract and employ great people, maintain and incrementally lift a culture of excellence, and behave in a sociably-acceptable way, recognising that the gifts that led to his leadership eligibility needed to be shared with the less gifted. That does not sound like many of our current leaders.

Communication skills were an essential medium.

These may be the skills required of a Chief Executive, but a useful board member would require at least some of the same attributes.

Most importantly, a chairman needs to have a group of people with whom he can work co-operatively, no energy wasted on individual grand-standing.

As a reminder of how such a board outstrips mediocrity, I recall a dreadful Auckland finance company board which had a gauche, but telegenic chairman, incentivised absurdly to sell the company, a board member paid excessively for his ''name'', who literally snored through some meetings, and a glib Chief Executive whose appointment was apparently also made to facilitate the sale of the company, rather than make it succeed.

The major shareholders dominated planning, which was hardly strategic in its nature, and some very ordinary complaisant folk were put into management positions, because they were willing to jump when so instructed, or be silent when the shareholders demanded.

Was it any wonder that the other stakeholders, principally investors, were treated with disdain?

New Zealand needs a new leadership group to inspire much better governance and execution of strategy if it aspires to achieve any level near to excellence, and improve productivity.

Perhaps it needs a new breed of achievers, embracing a sensible level of diversity, to break through the current low ceilings that constrain lift off.

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SEMINARS

We are now planning our final four seminars.

Timaru – September 24 – 1:30 P.M. Sopheze, Caroline Bay

Tauranga – September 29 – 11:30 A.M. Tauranga Yacht Club

Auckland – October 5 – 11:00 A.M. Mt Richmond Conference Centre

North Shore – October 6 – 11 A.M. Fairways Event Centre, Takapuna

I will be able to meet individually with clients after each meeting.

Those who have not confirmed their attendance would help us immensely by confirming their plans now.

If numbers exceed Covid limitations we could hold two seminars in a city but will need to plan that now.

Thank you to the 1,100 people who have attended seminars in Kapiti, Wellington, Christchurch, Nelson, Palmerston North and Napier.

The seminars are entitled ''No Hiding From Risk''.

TRAVEL

Edward will be in Napier on the 28 and 29 of September. He has hired the boardroom of The Crown Hotel as his usual spot inside Mission Estate is undergoing renovations.

David Colman will be in Lower Hutt on 7 October.

Johnny will be in Christchurch on 7 October. Please notify us now if you wish to arrange a meeting.

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Taking Stock 10 September, 2020

Johnny Lee writes:

INFRATIL's tour of the country is underway, speaking to investors and the public alike about the company's recent performance, as well as forecasts for the medium-term future. Infratil senior people, Tim Brown and Matthew Ross, presented in Waikanae last week.

The meetings are useful, giving investors the opportunity to reconnect with the company and raise concerns or seek clarification regarding Infratil's direction. Few companies are as diligent at maintaining communication with its shareholders, earning Infratil plaudits as one of the best communicators on the Exchange.

This respect is mutual, engendering a sense of goodwill, best illustrated by the strong support given to it during its capital raising in June. While some companies struggled to find shareholder support earlier in the year, Infratil mustered support at more than double the amount sought from its seasoned investors, despite its exposure to Wellington Airport and the rather modest discount applied.

The predominant theme confronting them was uncertainty. Broader strategies, such as harnessing the global push towards de-carbonisation and increasing connectivity, have been side-lined by the more immediate concerns around the pandemic and the imminent recession.

Trustpower, covered briefly, is clearly viewed as a mature asset that resides firmly within its ''cash-generative'' strategy. Electrification of our national fleet, whenever this finally occurs, will lead to a rapid increase in demand for electricity, which Trustpower and Infratil hope to harness.

The closure of the Tiwai Point aluminium smelter is an unwelcome speedbump for the ''gentailers''. The electricity retailing sector is clearly becoming more competitive, squeezing margins for all participants. The regulator is also tightening its grip, cracking down on practices it considers anti-competitive.

The Vodafone acquisition prompted several ''Please explains'' from the gathered audience and, to run the risk of understatement, is clearly not a nationally beloved brand. Not many telecommunication companies are. However, Infratil is backing its horse, believing that with a local focus devoid of overseas interference, Vodafone can transform. With more people using more data, demand for more expensive products (such as ''endless'' or ''unlimited'' plans) is predicted to increase. Furthermore, the rollout of 5G may accelerate this process, as greater speeds allow greater consumption of data.

This rollout will have its own costs, but Infratil is confident that it will be able to monetise these new technologies in its favour.

Wellington Airport's story needed little explanation. The company has obviously suffered a crippling blow following the spread of the virus and its fate is largely out of its hands.

Infratil noted that, following the lifting of the initial lockdown, domestic demand surged and almost rebounded to previous levels. Clearly, our appetite for travel has not waned during this period. It was also noted that Wellington, as a region, has fared better than others on some metrics, perhaps owing to our large public sector and lesser reliance on tourism compared to some of the harder hit areas.

The runway extension was discussed, as the rationale turns from an economic basis to one of safety. Fewer, larger craft are being utilised internationally, requiring a longer runway to accommodate them. With the lockdown in effect, there appears to be no urgency in progressing this project yet.

Tilt, Longroad and Galileo all represent an avenue for growth, as governments around the world push producers to design and develop more investments into renewable energy. Wind and solar power will likely form a large part of this. During the meeting, it was noted that the US market, which Longroad competes in, is extremely competitive relative to New Zealand and Australia.

The real gem in Infratil's portfolio is CDC Data Centres (previously called Canberra Data Centres).

Infratil has long held the view that data storage will be a large driver of its future growth. It is noticeably more animated when discussing the future of data storage, using the example of the ''Covid app'' to relate to the audience. This data is securely stored in such a data centre.

Sensitive data, such as that held by certain arms of the Government, demand certain levels of security that make data storage a ''sticky'' business – meaning that once customers are onboarded, they tend to remain a customer. The best customer, after all, is the one that never leaves.

Several new data centres are in the construction pipeline, and clearly demand is outstripping supply. These assets have the potential to provide consistent recurrent revenue for Infratil. Until the competition catches up, Infratil will be able to command significant market power in this space.

Retire Australia attempted, unsuccessfully, to escape without notice. Very little was said about this asset, a collection of retirement villages in Australia, located mainly in Adelaide, Brisbane and Sydney. Statements regarding its lack of scale suggested there may be a secondary reason why little was said.

Infratil as a group is well capitalised, although comments regarding its funding model suggested Infratil would rather increase the proportion of debt it carries if the opportunity arose. Debt is significantly cheaper than equity, with most of its listed debt trading below 3%.

Overall, Infratil shareholders own a diverse asset, with exposure to telecommunications, electricity generation and data storage.

The year has been an extraordinarily challenging one, especially for Wellington Airport, but other parts of the business are continuing to grow and offset these struggles, illustrating the benefits of such diversification.

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Chris Lee writes:

AS wholesale interest rates head inexorably towards nil, and perhaps negative as early as February, the world of banking heads for a venture into uncharted waters.

That negative rates appear in no textbook ever read by people of my vintage will be unsurprising, and perhaps irrelevant. We will just have to adapt.

So will the NZX, whose software for its bond trading platform was written without an expectation of negative rates. How will prices be calculated on a bond that sells at a negative yield, or has a negative coupon?

The robot funds such as Simplicity will have manuals requiring them to invest in specific assets irrespective of cost or yield, perhaps explaining the price at which they bought Synlait Milk shares, for example, and dutifully would have reduced those holdings as the price paid fell away, the index weighting changing.

As an aside, a robot fund based on a committed buying promise might work for specialist areas of the market but is an illogical choice for mundane asset types, like NZ or Australian bonds or equities.

When Germany recently raised a billion or so in 30-year bonds at a negative rate, you can bet your favourite slippers that the only buyers were those funds investing Other People's Money, guided by an unthinking but unchangeable manual.

Negative or zero rates will punish investors who pay fees for others to invest into assets that by definition must lose.

The NZX, one assumes, will rewrite the software to create a platform for traders.

Our Reserve Bank has hinted of plans to move to a negative rate in February.

The NZX thus has five months to rattle its dags.

Just as perplexed must be the old school bankers, most of whom are retired, and even the new brigade might be pondering the ability of banks to attract retail deposits without any offer of a discernible interest rate.

Perhaps the biggest question is not when but how our traditional banking relationships will be disrupted.

If there is no return for risk, and money is virtually ''free'', how will a bank respond?

Another question might be how a populist, socialist Government will react to the bank preference to avoid lending risk, thus becoming the ''no'' bank for most business, rural and consumer enquiries.

It is a fair guess that the technology giants will enter the credit card/lay-buy world, funding at no cost and extracting margin from merchants, probably at a lower rate than the banks have somewhat greedily enjoyed for the 40-plus years that NZ has had credit cards.

Might one observe a Facebook, an Apple or even a Xero using their databases and technology to build a money-lending operation in New Zealand?

Might they go further and forgo the pitifully low margins for lending risk, replacing those margins with long-term profit-sharing, perhaps investing in a hybrid preference share that has no particular debt cost, but must offer equity-like returns when the business levels improve?

Could we find that NZ's small businesses, traditionally starved of capital, too small to list, become beneficiaries of a new type of banking that funds equity, with flexible terms, rather than debt, where any mishap leads to default?

Might the banks themselves see that a potential equity return can be measured as offering a better return for risk than the pitifully low debt margins visible today?

Imagine this concept coming into the funding of a first-time home buyer, the money advanced on the basis of a flexible, low repayment basis, but some sort of sharing of capital gains.

Jacinda Ardern and her public sector Mandarin, now our Minister of Finance, Grant Robertson, might easily be convinced that the tax-payers themselves should enter a new form of social banking, its core logic being not much different from what the late Jim Anderton wanted to see from the old Development Finance Corporation, or even what he imagined when he latched on to the concept of Kiwi Bank.

With great interest I will watch what will be the ''disruptive'' response to the banking profession now that money is virtually free, chasing returns for risk that are virtually non-existent, making equity returns arguably a better target than debt returns.

Do not imagine this thinking will not be tested soon.

Our Government already has the Reserve Bank, through the Inland Revenue Department, lending $10,000 sums at zero cost to any small business owner who can spell his name and name the All Black Captain.

Many a boat, a jet ski, a new set of golf clubs or a week in a skiing resort has benefited from this munificence.

Japan's Government uses tax-payer money (and debt!) to buy shares.

America is now buying unrated corporate bonds.

New Zealand ''lends'' to any small business which asks for a loan.

Rates keep falling, negative interest rates arriving, possibly in February.

Will the end result be that in New Zealand the provision of equity (capital) is a better risk/return proposition than lending free money and having formulae that force write-downs?

The moon, most definitely, now has the whiff of cheddar.

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Seminars rescheduled

The postponed Timaru seminar is now planned for Thursday 24 September, at Sopheze on the Bay, beginning at 1.30pm.

The postponed Tauranga seminar is planned for 11.30am on Tuesday 29 September, at Tauranga Yacht Club.

Any plans for Auckland must wait until Covid levels allow.

City Visits

Edward will be in Napier on the 28 and 29 of September. He has hired the boardroom of The Crown Hotel as his usual spot inside Mission Estate is undergoing renovations.

To ensure that we have correct numbers to comply with any Covid levels, please let us know if you wish to attend either seminar.

Chris Lee

Managing Director

Chris Lee & Partners Ltd

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Taking Stock 3 September 2020

It would be a 2020 miracle, bestowed upon investors and the people of New Zealand, if we do not find the Covid virus popping up in cities south of the Bombay Hills, once the asymptomatic Aucklanders resume travel this week.

Investors are entitled to believe in miracles.

Surely, they witnessed such divine, benign intervention when the various large-scale retirement villages reported no Covid cases in their villages or care units when the virus arrived in March.

Investors rejoiced when the carnage was avoided.

The share prices of companies like Ryman, Summerset and Oceania had fallen by more than half five months ago, in fear of Covid invasion of the thousands of units in the villages of the major operators.

In February, the Government, the Health Department and the Ministry of Foreign Affairs and Trade had been presented with a report estimating that perhaps 100,000 New Zealanders would perish, tens of thousands most at risk from living in close quarters in care facilities.

Not unreasonably the boards of directors at Ryman, Summerset, Oceania and Metlife had to ask themselves how they could survive such losses. Was the model likely to perish at the hands of a deadly virus?

Who would want to live in a rest home or care unit if such a facility was at risk of infestation of a virus that is at its most potent for elderly or vulnerable people living in close quarters?

Such board meetings must have been tense and unpleasant. For more than two decades I had chaired the board of such an organisation. We often faced tough decisions, usually related to revenues, debt, sales, the need to upgrade infrastructure and upgrade facilities.

Never did we face a plague.

For those who govern the sector and those who execute strategy, and those who set the nursing standards, my admiration is replete.

The sector's governors, executives and nursing staff have simply done a wonderful job.

In effect, Covid has been kept out of Ryman, Summerset and Oceania, and no doubt others.

Britain, Australia, and Canada, all backed up by far better health systems and facilities than New Zealand can afford, have lost very large numbers of rest home/private hospital residents.

In Canada, according to a family member, the sector is too impersonal, too institutionalised, and owned by investment companies, rather than domestic companies specialising in healthcare.

In Britain the losses were unpardonable, allegedly caused by shocking leadership.

The USA losses are extreme, perhaps also the result of leadership failure.

Here, the instant, strong response somehow produced a miracle. New Zealand did not lose 100,000 people or 80,000 or even 2000 - the minimum number assessed by the most optimistic modelling.

To date we have lost 22 people, 16 in just two, privately-owned, rest homes in Auckland and Christchurch.

Ryman’s share price has responded by doubling since those frightening days in March. So has Summerset's share price been restored. Oceania's price has almost trebled.

In March investors feared the outcome.

Understandably many sold out, unwilling to await an outcome that might have destroyed the faith New Zealanders have in the big retirement village operators.

Presumably, those investors assessed their own risk tolerance and reduced or even eliminated their exposure to a sector that prior to Covid had seemed like one of the most resilient and profitable of all the sub-sectors in real estate.

May our lenders in the sector be as successful, and blessed by another miracle, should another major wave of the virus rampage through the country.

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THE late Lloyd Morrison, who died of leukemia at an awfully young age, was one of New Zealand's most charismatic and convincing business leaders, a man of charm, wit, and intelligence.

He straddled the political, infrastructural, and capital market sectors, his insights and forecasts more often fruitful than failed.

He had formed OmniCorp as an investment vehicle in the 1980s. It collapsed in 1987, a victim of a mix of illiquid, over-priced assets funded with too much debt to survive a liquidity crisis, during which banks focused on their own survival.

Morrison went on several years later to list Infratil, which sought to specialise in infrastructure investments, funded with equity and very long-term debt, to avoid the fate of OmniCorp.

Infratil’s successes are well understood, the company itself listed, but its management provided by an unlisted Lloyd Morrison company, Morrison and Co, paid, not ingloriously, for its management services, and somewhat oddly, further paid by incentives when ambitious benchmarked targets are exceeded. (Quite why bonuses are needed to ''align interests'' is a mystery to me.)

Infratil's funding has been superbly supervised for all of the past 26 years by Tim Brown and his team.

They have stayed out of the clutches of nervous, fairweather bankers, the type who OmniCorp might have endured, Infratil preferring to issue usually generously-priced retail bonds with long maturities and flexible covenants, enabling Infratil to match its long-term assets with long-term debt, and ample equity, rather than use dangerous bank debt.

Since 1994 I have been an enthusiastic Infratil investor and holder of its debt, as have thousands of our clients.

Lloyd Morrison and his company have made some highly successful investments, in energy, particularly renewable energy and, in more recent times, in data protection.

It has made money from its holding in Wellington Airport, and no doubt made profits during its brief ownership of Auckland Airport and Port of Tauranga, where it sold out, unable to obtain enough shares to influence board decisions.

Its foray into public transport was probably not its smartest call and its long-term commitment to regional airports in Europe destroyed shareholders' funds, that strategy pursued for rather longer than was prudent.

But if you asked our Infratil investors to mark the company there is little doubt that it would receive a high pass mark, based on its constant flow of debt instruments, where all bar one would win investor approval.

The exception, of course, was the perpetual bond, repriced each year, at 1.5% more than the one-year bank swap rate, a margin that today is absurdly low for a perpetual security.

The error Infratil made was in failing to review that margin at predetermined intervals, a recommendation Mike Warrington had made all those years ago, when he was working at Infratil's bank, ANZ.

Infratil has argued that to repay those bonds at par now, or re-price them, would advantage those who bought the bonds on the secondary market at a discount, at the expense of the shareholders.

This, in my view, is just a risible response. How much anyone paid for the bonds is none of Infratil's business. Neither is it Infratil's ''business'' to know how much people paid for those shares that Infratil is now buying back. Infratil owes every bond-holder $1.00 for each bond. The lack of a pricing review was an error. Perhaps it was a conscious error, perhaps not. It should be fixed. But it will not be, while the company takes a legal, but not moral, stance.

This bond was not Infratil's only error, even if one disregards the investment mistakes, which include an unwise foray into Retire Australia, a poorly-managed Australian retirement village operation, from which Infratil should have exited years ago.

In my view it has also erred with the incentives granted to Morrison & Co, resulting in ''bonuses'' for its generously-paid manager.

These bonuses, now payable, exceed $100 million, a windfall that would cause most to blush.

Wisely, the Infratil independent directors are discussing a payment via a share issue rather than in cash.

One can imagine the response to a $100 million, five-year bond issue if its stated purpose was to pay bonuses to its managers.

Undoubtedly, Infratil's successes have rewarded shareholders, and if the current share buy-back is sincere and evidence of an intelligent belief that the shares are under-valued, further share price increases might be achieved, to the advantage of all.

But the company must recognise that the issues of the extremely generous bonuses, and the inappropriate design of the perpetual notes will be conflated by many investors.

If the investment in data protection is so valuable that it, along with other foreign investment, has justified a life-changing bonus, then other stake-holders, like the perpetual note-holders, must naturally wonder how much of Infratil's successes have been funded by mis-priced perpetual bonds, and why these windfalls are not used to put right an egregious wrong.

The extraordinary investment successes should be used to cleanse this error.

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JOHNNY LEE writes:

A SERIES of cyber-attacks, periodically crippling the NZX platform, dominated the news within financial circles last week.

The attacks, apparently originating from overseas, resulted in the market being closed and prevented anyone (including Chris Lee and Partners) from trading in New Zealand shares on the Exchange during the outages. The attackers were believed to be demanding a ransom, in the form of cryptocurrency, in exchange for their assurance that the attacks would cease.

Friday's attack almost immediately followed an unfortunately timed announcement from the NZX that the market would open as usual. The market eventually opened at 1pm.

One obvious conclusion to this issue will be to reinforce the value of dual-listing. While the New Zealand market was in halt, institutions began trading freely on the Australian market. Retail investors largely do not have this option and were forced to wait. Shareholders in companies listed only in New Zealand faced a similar dilemma.

The impacts of this on the NZX vary. Trades occurring on overseas markets are permanently lost revenue for the Exchange. Those waiting for the Exchange to re-open simply delay revenue. Largely, the damage is reputational, though not to the level that would justify some of the bleating published in local media.

A closure of our exchange will only be a mild inconvenience to most shareholders. For day traders, it will mean chaos, unable to settle transactions or take advantage of market movements as they occur. Day trading is an activity fraught with many risks.

The NZX will no doubt be conducting a thorough set of reviews of its core systems, including penetration testing, to ensure it is as robust as possible. An immediate area for improvement for the NZX should be communication, perhaps using social media tools to keep the public better informed while its front-facing website is offline.

For now, the NZX appears to have resolved the issue. Temporary arrangements were made with the Financial Markets Authority to allow the NZX the option of having the market remain open if the NZX site was brought down again.

Now that the dramas are concluded, investors can focus on the conclusion of reporting season, with Heartland Bank and the retail stocks to report later this month.

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AT THE same time as these cyber assaults, office supply retailer OfficeMax announced its intentions to shift to an entirely online model, closing its physical locations and laying off staff.

The shift from physical to digital is a global one and was occurring prior to the outbreak of Coronavirus this year. Consumer habits are changing. Store closures also tend to be a self-fulfilling prophecy in this regard – as stores close, people find fewer reasons to visit their local shopping complex, which in turn prompts more store closures.

One clear risk to operating an online platform like this is the aforementioned risks of the delivery channel (a website) losing functionality, a risk that is especially relevant in competitive industries. Traders wanting to sell shares must wait for the NZX to re-open. Consumers wanting to buy clothes can simply go to a different website.

The move away from bricks and mortar is widespread – clothing stores, banking and even groceries – and investors should remain vigilant towards these shifts in consumer patterns when reviewing their portfolios.

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THE RECENT flurry of retail interest in our sharemarket is undoubtedly a boon for all within our industry, but care must be taken to ensure the mistakes of the past are not repeated.

It has only been in relatively recent times, perhaps the past decade, that has seen investors return with confidence to our sharemarket. The crash of 1987 left many with a negative perception towards share ownership, believing the stock market to be an unregulated mire of inside information and market manipulation. Sadly, this attitude was not entirely unfounded in that era.

Today, of course, standards are higher within the NZX. Some of those who abuse inside information, even inadvertently, have been named and shamed. Those who manipulate share prices are increasingly caught and punished.

However, the surge in retail activity must be tempered with a drive towards greater financial education. There is undoubtedly a growing interest in listed companies that could charitably be described as speculative – companies with virtually no revenue, little track record and a volatile share price. Institutional interest in these companies is almost nil.

Our schooling system offers little in regards to financial education. Those who choose not to engage with the financial advice sector rely more heavily on social media and personal experience to make financial decisions, a method that lacks objectivity and independence. Public media reporters are rarely trained in analysis of financial market data.

A reliance on the family unit to teach financial literacy disproportionately benefits the wealthy and does nothing to break cycles of poor financial knowledge. Recent efforts by the Financial Markets Authority, no doubt well intended, have missed the mark, so far.

Kiwisaver has been a useful tool in this regard, separating investors from the responsibility of making decisions beyond a simple strategy. The better Kiwisaver fund managers are passionate about ensuring that people understand their investments, including the rationale behind asset allocation.

Earlier this year, financial markets saw a lull in activity following the wake of the pandemic. There was a dearth of certainty, horrific figures emerging from the likes of Italy, and a predictable flight to cash as people took profits and generally battened down the hatches.

Now, investors are returning, some with confidence, others out of necessity when faced with a low interest rate environment. Some want to gamble, egged on by their peers.

It is crucial that those foregoing financial advice and choosing to focus their energy (and savings) on small, unprofitable start-ups are reminded of the benefits of diversification, lest we end up with another generation of people distrustful of financial markets.

Seminars

We are beginning to plan our deferred seminars. We hope to run meetings in Tauranga and Timaru this month, though our plans for Auckland must wait until Covid levels allow.

We have tentatively booked our Timaru presentation for Thursday 24 September at Sopheze on the Bay, beginning at 1.30pm. Please make a note of the date. We will email all those who indicated they would attend and will publish the confirmed date in our newsletters.

City Visits

Edward will be in Napier on the 28th and 29th of September. He has hired the boardroom of The Crown Hotel as his usual spot inside Mission Estate is undergoing renovations.

 

Chris Lee

Managing Director

Chris Lee & Partners Ltd

 

 

 

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