Taking Stock 16 September, 2021

FOR about 65% of the population, any discussion on interest rates is about as riveting as new legislation in Germany on the fat content of pet food.

For about 25%, who have mortgages or business debt, the fear is of a chunky rise in the servicing cost of their borrowings.

But for 10%, any significant rise in interest rates is akin to a pay rise.

It is the latter group who will now be cheering, as the various factors that drive interest rates upwards begin to conflate:

- The Reserve Bank is itching to slow the increase of inflation, by raising the overnight cash rate;

- The Australian banks operating here are being bullied by the Reserve Bank into raising hybrid capital (debt dressed up as equity), totalling billions, to shore up bank reserves;

- Corporates are rightly fearful that changes in economic conditions, coinciding with constraints on banks, will lead to the Australian banks restricting their lending, and/or applying more rigid covenants on corporate loans. Logically, the cleverest, most indebted corporates, like Wellington International Airport, will want to raise retail debt to repay the banks, before market conditions react.

Conflate these three changing conditions and the most reasonable expectations will be a genuine rise in bank deposit rates and corporate bond yields, though this will be a view not necessarily accepted, some believing that Delta will lead to a prolonged recession.  However I expect a rate rise, soon.

If I am right, the 10% who manage their own savings would cheer loudest. Those whose savings are in Kiwisaver funds and other managed funds would need to mute their enthusiasm until the fund managers have fessed up to the losses when they mark to market their fixed-interest portfolios.

To convert this last observation to everyday English, the fund managers who have bought long-term, very low-yielding bonds and notes would need to report that these securities are worth much less than they were a few months ago, when yields were at an all-time low.

This would lead to write-downs, and some ugly negative influences on those funds' performances.

Some will argue that these write-downs would be a timely reminder of the dishonest marketing of such funds when they report a final annual return comprising real interest received and TEMPORARY paper gains, caused by the short-term increase in valuations when interest rates are falling.

When gains are reversed, the returns of previous years will be seen as misleading.

Yet eventually all investors in fixed interest will gain when rates rise.

Others will argue that the fund managers made a crass error when they invested other people's money into long-term bonds, at one stage some months ago at rates of around 0.6%. Those investing other people's money were probably reacting to the message that even NZ might succumb to the concept of negative interest rates.  The dopiest of fund managers provided long term mortgage finance at rates that now look silly.

From all of this, the smartest to emerge will be those who accepted pitifully low short-term rates – sometimes literally nothing – while they waited patiently for rates to revert to the 3.0%-4.0% range that we are now seeing.

A year at nil, followed by nine years at 3%, is immensely more rewarding than 10 years at 2%, if you can afford the first year of nil.

Patience is indeed a virtue.

Most who manage their own portfolios use banks for short-term rates (up to two years), as the fee involved in buying bonds for short terms destroys yields.

These investors then look to build a ladder of notes and bonds, gaining better returns and locking in the income on which they rely.

The smarter investors will use bonds that have any of the following features:

- The notes are issued by regulated banks with high capital levels and an established ability to raise equity in tough times;

- The notes are issued by profitable, dominant corporates with credibility gained by a history of success;

- The notes are secured by meaningful, easily-valued, tangible assets.

The securities most feared are those that are subordinated and issued by companies whose real assets are intangible, or by companies still striving to achieve stability.

In recent weeks, Oceania Healthcare, with bonds secured by property, ANZ, a well-capitalised bank, and Wellington International Airport, a dominant corporate, have announced new issues. The first two discovered ample appetite for their offers.  I expect WIAL to discover full demand for its $100 million offer.

Oceania paid 3.2%, ANZ paid 2.999% and Wellington Airport is offering a minimum of 3.25%.

Investors would be smiling if their brokers were allocating even a scaled-down amount to every applicant.

More issues will follow, the Australian banks certain to be following the ANZ, offering subordinated notes at fixed rates for many years, and probably a renewal formula should the banks be denied by the banking regulator the right in any particular future year to repay in cash.

Now is a much better time to be updating fixed-interest portfolios, than any time in the past 18 months.

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LAST week's Taking Stock gently chided the greed and incompetence of many receivers and liquidators, noting that the major accounting firms, like McGrathNicol and Grant Thornton, had behaved disgracefully with their tasks at South Canterbury Finance.

However, I should have richly praised Robert Walker, the clever, dogged, brave insolvency practitioner given the task of untangling the messes of David Henderson's contrived business failure at Property Ventures Group (PVG).

Henderson, it should be recalled, was the tax evader and serial bankrupt who claimed a victory against the Inland Revenue Department, decades ago.

In doing so, he could be likened to a sniper whose rifle managed to shatter a window before he was blown to pieces by armoured tanks, his subsequent battles with the tax department suggesting his initial one-shot hit was of no significance at all, if judged by the ultimate outcome.

Henderson had spent decades creating an illusion of creditworthiness that sucked in multiple finance companies, guided by a clever solicitor and aided by the oddball politician Rodney Hide, who has often praised Henderson, and sometimes invested in Henderson's structures.

Henderson's extreme use of debt, his almost total blacking out of transparency, his serial defaults, his back street cunning and the followers of his ZAP (Zenith Applied Philosophy) Scientology teachings, created a labyrinth that few insolvency practitioners could penetrate.

Unbelievably, a now-retired PwC accounting partner, Maurice Noone, then colloquially nicknamed the South Island Rainman for PwC, arranged for PwC to audit the Property Ventures Group mess, in return for 20, or maybe 30 pieces of silver.  Or maybe 10.

The failings of PwC in this audit process were blamed by the unpaid creditors when PVG was shown to have no ability to repay its $100 million (plus) creditors.  The audit process had been amateurish.

PwC's insurance policy, probably aided by the contributions of PwC partners, stumped up many tens of millions with an out-of-court settlement arranged by the insolvency expert Walker, whose case was part-funded by a litigation funder, LPF.

Whether the out-of-court, out-of-sight settlement was $30million or $60million has never been revealed.

Whatever, PwC's capitulation was a great victory for Walker, whose task was similar to searching for wedding rings in a myriad of blocked sewerage pipes, housing a resident crocodile.

Walker was a hero.

The PVG creditors had a return that must have been tens of cents of each dollar lost, thanks to him and his litigation funder.

So here is the punchline.

Walker, having successfully attacked a Big Four accountancy firm (PWC), is now dependent on a  licensing process determined by the accountants' institute. It is seeking to ban him from practising his craft.

After his monumental effort in dealing with a Machiavelli as a bankrupt, Walker's health was depleted. He has, at least temporarily, retired. His health may become a debating point seized by the panel which judges him.

Whether or not he is banned from practising, he should be honoured as one of the most courageous and persistent pursuers of a just outcome for creditors that New Zealand has ever seen.

Do you wonder why none of the big firms took on the task of tackling Henderson's mess?

Do the initials OBN ring any bells?

Do we really want accountants to be their own regulator, with the power to preserve an OBN that has served New Zealand poorly?

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Johnny Lee writes:

The demerger of Fabric Property Group, an off-shoot from listed property trust Stride Property Group, will introduce a new listing on our exchange in early October.

An important point necessary to preface this article is to note that Stride - SPG listed on the NZX - is a stapled security and as such confers ownership of a group including Stride Property Group, which owns and leases property around the country, and Stride Investment Management Group, which manages property for various entities, including listed property trusts Stride Property Group and Investore.

A demerger occurs when a company ''spins off'', or structurally separates part of its business to create an independent, stand-alone entity. This is usually done when the objectives of the subsidiary no longer align with the overarching entity, in this case giving Fabric the opportunity to pursue growth in an avenue external to Stride's own objectives.

Other examples of demergers include Tilt Renewables' demerger from Trustpower, or South32's demerger from BHP Billiton in Australia.

Stride established Fabric late last year as a subsidiary created to own commercial property in the ''Office Building'' sector. Following the listing, Fabric will have a value (market capitalisation) of about $600 million, or a fifth of the size of Precinct Properties, another major listed property trust specialising in office space.

As part of the demerger, shareholders of Stride will receive shares in Fabric at no cost. Stride shares will fall in value, theoretically matched by the value of the Fabric shares themselves. In practice, market forces will determine the exact outcome.

The demerger allows Stride investors to either pursue an exposure to office property (buying Fabric shares) or ''town centre assets'' and property trust management (buying Stride shares).

Stride will retain a large minority (roughly 30%) shareholding in Fabric. While Stride has not entered into an escrow agreement, it has committed to hold the shares until May 2023.

Fabric has also elected to employ Stride Investment Management Group to act as its external manager.

One of the major issues with this structure is the obvious conflicts of interest that exist for the external manager. These are not hidden – in fact they are clearly highlighted on Page 47 of the 103-page Product Disclosure Statement – and the company will be very careful to ensure a robust policy is in place to minimise any perception of acting in conflict.

This conflict exists because Stride Investment Management Limited also manages assets for Investore and, more importantly, Stride Property Group. The Product Disclosure Statement cites the example of a central Wellington office building currently owned by Stride Property Group being sold to Fabric.

While the actual management of these conflicts is achievable, the perception is ultimately more relevant. For example, if said Wellington office building encounters problems after its development and sale to Fabric, Fabric shareholders would rightfully question whether their company is being treated as ''second-class citizens'' by the overarching management group. Stride will be aware of this and will be at pains to ensure that any process which concludes with a transfer of assets from one managed group to another is completely transparent and in the interests of both groups of shareholders.

Another issue with the proposed offer is the fees accrued to the manager. The fees are expected to equal about 16% of total revenue. These fees exist partly ''to incentivise the Manager to ensure transactions generate value for the Fabric portfolio'', a turn of phrase that is unworthy of anyone's vernacular, least of all a listed company. Imagine if Stride were to claim that they were not motivated or incentivised to manage Fabric in an optimal way.

These external management contracts have largely fallen out of favour among investors, due to the imbalance of risk and reward that inevitably occurs. Precinct was the most recent listed property trust to exit its management contract, buying out AMP Haumi Management Limited for $215m in order to manage its own buildings. Vital Healthcare's ongoing dispute with its external manager (Northwest) is well-known, and led to efforts from major shareholders to rein in the eye-watering fees charged by Northwest, presumably charged to incentivise them to ensure they added value as opposed to, say, not adding value.

Ironically, Stride itself is an evolution of DNZ Property Fund, which gained notoriety a decade ago following a dispute with its external management team, and had to pay more than $30 million to rid itself of an unwanted management contract.

Fees charged by Stride Investment Management Limited to Fabric include asset management fees, transaction fees, leasing fees, debt capital raising fees, property services fees, accounting services fees and, of course, performance fees. The offer specifically states that the fees cannot be changed by Fabric or Stride Investment Management Limited.

One must assume that, as part of its process of selecting Stride Investment Management Limited to the role of external manager, Fabric conducted a thorough and transparent tender process to ensure Fabric's new shareholders maximised the value of an external manager.

For Stride, the divestment is absolutely logical. The group was able to raise capital last November to purchase new assets, before selling them to investors a year later while maintaining an undeniably lucrative management contract. If Stride is to continue this path of incubating property assets before divesting on market, then shareholders of Stride will be pleased to see the accompanying growth in management fee income accruing to the group.

For potential investors in Fabric, the question one would ask is: why invest in Fabric over other, larger, more established owners of commercial office space? The company and its lead managers will now be pitching their argument for why Fabric is the superior choice.

Precinct Properties, while not necessarily a comparable peer, is an example of a listed property trust that invests in the prime commercial office space. Depending on how Fabric is priced, it intends to offer a dividend yield of between 3.6% to 3.8%, forecasted to lift slightly in future years to about 4.3%. Precinct pays a similar dividend yield (3.9% at time of writing) that is also growing, and has a market capitalisation about five times larger than Fabric. Obviously, other factors form part of the investment decision, but potential Fabric investors will logically be seeking a competitive advantage offered by Fabric over other alternatives.

Overall, the transaction is good news for investors wanting additional options to consider for investing in office property or property trusts. It is also good news for shareholders of Stride Stapled Securities, as it enjoys yet another lucrative management contract for its book.

Advised clients considering investing into Fabric, or those holding Stride and are about to receive shares in Fabric, are welcome to contact us to discuss further if they wish. We will also display our view on our client-only research page.

TRAVEL

Chris plans to be in Christchurch on Tuesday October 26 and Wednesday (am) October 27. Any client wishing to arrange a meeting is welcome to contact the office.

If Covid allows, he intends to be in Auckland in early October and to conduct seminars in November, in North Shore, Auckland, Tauranga, Napier, Palmerston North, Kapiti, Wellington, Nelson, Christchurch and Timaru, and elsewhere if feasible.

Chris Lee

Managing Director

Chris Lee & Partners Limited


Taking Stock 9 September 2021

EVERY business that has ever had to write off a bad debt as a result of a receivership will currently be praying that Chartered Accountants ANZ (formerly the Institute of Chartered Accountants) is coming to the rescue.

Chartered Accountants ANZ (CAANZ) last week promised that the new regime for receivers and liquidators will lift standards for the betterment of all.

The new rules came into effect in September and place the accountants' institute in charge of deciding which receivers are competent, which are not, who should be granted the privilege of being ''licensed'' and who should not.

Once we get to the point where the accountants' institute sets the standards, the toxic behaviour that has so deeply damaged the reputation of insolvency practitioners would be a problem no longer, according to the CAANZ.

Let us hope the CAANZ is right. It will need a new, industrial-grade broom to sweep away the muck of the past.

The reality is that, with very few exceptions, the worst outcomes for creditors and shareholders during my 46 years of work in financial markets have been delivered by the major accounting firms.

If the country wishes to put the accountants in sole command of licensing, and make them the judge of what are acceptable standards, we should all assume the kneeling position and seek divine intervention.

I guess the thread of hope is that this new level of omnipotence, and omniscience, inspires the accountants to douse themselves in honesty and set about a cleansing of the rotten practices that have generated such cynicism and criticism, with practices such as:

- Selling assets without first creating buying tension, resulting in fire sale prices;

- Favouring the banks and other secured creditors by making minimal efforts to rescue money for unsecured creditors and shareholders;

- Selling assets to ''friends'' of the business;

- Paying unchallenged, often ludicrous, bills to third parties for their ''advice'' on legal processes or asset valuations;

- Allowing third parties to sell assets in a time frame that is convenient, rather than logical;

- Appointing small town receivers, ''friends from university days'' to ''assist'' with receiverships, a practice that discourages transparency;

- Refusing to sue trustees, bankers, lawyers, and errant directors who happen to have been influential in choosing the receiver.

These are all toxic practices; selfish, lazy, and greedy.

Of course not every receiver is guilty, nor are we without some excellent lawyers who fight for justice, rather than pursue ever fatter fees.

But we need solutions. I doubt the CAANZ will pursue change with vigour.

One solution would be to have a creditors' committee oversee processes and performance, and to grant that committee the right to fire the receiver/ liquidator/ statutory manager.

Another solution would be to have a judge rule on all rotten outcomes.

Another solution would be for creditors and shareholders to approve all charges, before they are paid, being especially vigilant with third party charges.

For many lucky people, there may be little understanding of how bad the process, and performance, can be.

So let us use an example;

Say a business fails owing the bank five million and creditors another five million. Let us say external shareholders had invested a further five million into the failed company, its cashflow ruined by bad debts and slow-moving stock.

So the bank cancels all credit and appoints a so-called reputable accounting firm as receiver, instructing the receiver that it wants its five million back within six months. As the secured creditor, the bank is effectively in charge.

The failed company has seven million worth of debtors, four million of stock, and three million of plant and equipment. The receiver quickly identifies that half of the debtors can be recovered by settling disputes, writing down the debts, agreeing to accept 50 cents in the dollar in full and final settlement.

The receiver discovers the stock valuation is unrealistic but that he can quit all stock immediately to a broker for 30 cents in the dollar.

So he will recover $3.5 million from debtors, $1.2 million from stock, making $4.7 million. The bank wants $5 million. The receiver, for all practical purposes, can charge what it likes fattening out bills, and can authorise third parties, like lawyers, to charge what they like. If $6 million is quickly recovered the bank, the receivers, and the lawyers can all be paid.

The receiver now has $4.7 million in cash and $3 million of plant and equipment. Along comes a friendly party – New Zealand is a small country – and wants to buy the plant and equipment.

''Give us $1.3 million and you can have it'', the potential buyer is told.

Within weeks the receiver triumphantly declares the receivership, or more accurately the liquidation, is cleared, the secured creditor paid in full, the receivership costs met in full.

Bad luck for creditors and shareholders. They will never learn what the debtors, stock, plant, and equipment might have been worth had an honest process been completed.

Now obviously I am conflating the processes of receivers and liquidators.

In theory the receiver, let's say a Big Four accounting firm, may hand over to a liquidator. Remember, in New Zealand we have a closely-knit Old Boys Network.

Would the liquidator be a corporate friend or a competitor who wants to highlight the insidious networks that produce these bad results?

There are some excellent people I have met in this murky world of receivers and liquidators.

One of them worked for BDO Spicers and was a gutsy street-smart character, who would not blink in a backstreet knife fight.

He retired early. His views would be interesting.

The controversial Auckland operator Damien Grant is another with a reputation for not blinking.

He deserves extra credit for having recovered from stupid errors in his life when he spent time in jail, but now uses all of his worldliness and experience to win applause from creditors and shareholders. The other receivers tried to ban him from a licence. They failed.

The lazy, fat corporate world has very few who prioritise returns for the secured creditors, the unsecured creditors, and the shareholders; not none, but far too few.

Will the accountants' institute now press for much better performance and for creditor overviews?

Or will they use the inept, lazy law changes made by the Ministry of Business, Innovation and Employment (MBIE) to ''paint a pig with lipstick'', as someone once described some of the moronic behaviour of those who so failed in their obligation to all parties when South Canterbury Finance was wound up by inept people, who retired as soon as their failures were visible.

Creditors and shareholders should adopt the kneeling position.

I suspect prayer is their best hope, until we have an MBIE and Commerce Minister with useful knowledge, energy, and a sense of justice.

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OF course, many in the privacy of closed boardrooms will opine that it is not only in cases of company rescue that accountants and lawyers are allowed far too much influence.

Though none are likely to speak out, the truth is that the companies that perform best rarely invite accountants and lawyers to have much presence in governance.

Science, technology, engineering, and production all regularly feature in the curricula vitae of directors running our best companies.

Genuine knowledge and experience, those blessed with analytical minds, those who understand strategic advantage, are characteristics of a successful company.

Accountants and lawyers might be called in for specialist advice when needed but real businessmen are in charge of developing strategy.

Such boards do not want corporate politics to intervene. They are not influenced by social commentators or irrelevant trends.

Evidence of this can be seen in the spectacular success of the country's most valuable, NZ-developed company, Mainfreight. Last month it was wrongly described as the first of our NZ companies with a share price of $100, an honour that Xero has achieved even if its shares are now listed in Australia (at A$150).

But Mainfreight's value is extraordinary, the more so in that just 17 months ago when Covid first arrived its share price was judged as being ''expensive'' at $30 a share.

Great credit goes to its founding chairman, Bruce Plested and its managing director, Don Braid, both of whom have been in their roles for decades.

The other directors are Richard Prebble, once, ironically a politician and a lawyer, Bryan Mogridge, Simon Cotter and a recent addition, Kate Parsons, who has expertise in technology.

The five NZ executive management team are all men who have been with Mainfreight for a decade or more, the four executives in Australia are all men who have been there for 10-30 years. The six executives in America are men who have been with Mainfreight for an average of 14 years. The executive in Europe comprises four men and a woman, who have served an average of 14 years. The four global executives are men with an average of 25 years with Mainfreight.

So what we have is New Zealand's most successful, truly global company, based in Auckland, its share price hovering around $100 per share, its profits growing steadily since it listed nearly 30 years ago. Like Fisher & Paykel Healthcare, it is a genuinely global company.

Mainfreight grows its own executives, its directors rarely change, its commitment to excellence is undoubted . . . yet it completely ignores some of the modern academic theory that seeks to assess excellence with academic criteria when reviewing governance and management.

Mainfreight displays intense interest in relevant social issues, such as climate change, water wastage, and social cohesion, but other goals of academia, such as the need to cater for others with diverse genders, lifestyles, and ethnic backgrounds, do not interfere with its pursuit of excellence.

Between its board of directors and its executive management globally, it engages 23 men and two women, all of whom, at least by photographic evidence, appear to be between middle age and what I would call ''senior'' age.

There seems to be no weighting for lawyers and accountants.

The biographies displayed all refer to relevant, private sector, business skills and experience. Wisdom is self-apparent.

Defying the so-called evidence of university studies into corporate excellence, Mainfreight displays a preference for knowledge, experience, commitment, and loyalty and has no policies requiring people to retire at any particular age.

Is it a statistical anomaly? Or is it evidence that an excellent company, relying heavily on culture and a commitment to long-term success, has better things to do than argue about academic or social theories?

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Johnny Lee writes:

THE soaring price of carbon observed over the past week has created a windfall for investors in the unique CO2 fund. The price per unit of the fund has increased almost 20% in the past two weeks alone.

CO2 is a listed instrument on the NZX, allowing anyone with a Common Shareholder Number to buy them, as they would any other share, and gain direct exposure to the price of carbon credits. The fund, managed by Salt Funds Management, has chosen to invest predominantly in New Zealand but does include a small holding of Australian carbon credits. The management fees are not inconsequential, perhaps reflecting the complex nature of the product and the lack of choice investors face for gaining such an exposure.

The introduction and operation of an Emissions Trading Scheme (ETS) in New Zealand has not been without criticism.

Criticisms have centred around the calculations of emissions, usage of international credits, exclusions of certain sectors and the effectiveness of the scheme as a way of actually reducing emissions, rather than simply increasing costs.

Nevertheless, the price of these units has soared in recent weeks, as companies seeking to pollute increase their ''allocation'' of our national ''budget''. Believers in a perpetually increasing carbon price – driven by a dwindling supply of credits and an increasing demand to own them – have been handsomely rewarded.

Of course, carbon credits have a value simply because we choose to give them a value. Carbon credits themselves do not create anything – they simply exist as a way of quantifying and pricing our national plan to reduce emissions and, hopefully, incentivising firms to actually reduce their emissions and therefore the additional cost the credits impose.

The fund had a slow start. For years, the fund saw little interest, and trading activity was extremely low. The price fluctuated between 90 cents and $1.10 throughout all of 2019, before lifting to $1.40 in 2020, before trading around $2 today. Millions now change hands each month.

Mechanisms exist to prevent these wild swings in price. This includes the ability of the Government to introduce a large number of new credits, effectively boosting supply to dampen the price. Thresholds must be met before this can occur – but these thresholds were met at the last auction and failed to cause a drop in price. Future thresholds to force more supply are looking increasingly plausible each day. The Government has stated that these increases in supply would be unwound in future years, meaning that although the can has been kicked down the road, there may be a race to pick it up soon.

In theory, supply and demand should also prevent such swings. ''Polluters'' have the option to target reductions to their emissions. However, it is often cheaper to simply buy the credits. For those earning carbon credits – primarily forestry owners – the increasing price should encourage activities to continue earning these credits. The increasing price suggests these sequestration efforts are not keeping pace with demand.

Last week marked the third auction this year. It was also the third time this year that demand greatly outstripped supply, and the third time the price rose to accommodate this imbalance. The final auction for the year will occur in December.

For traders and investors, the fund represents an opportunity to financially gain from the escalating price of carbon. As it is a political instrument, there are certain risks with the investment that cannot be mitigated.

And while it is not necessarily an investment into a traditional value-adding enterprise, market forces are driving the price upwards as New Zealand navigates its way towards its emission reduction targets.

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THE ongoing struggle between Philip Morris and global healthcare experts regarding the ownership of British firm Vectura is nearing a conclusion, with six days left for shareholders to decide whether to accept the offer or retain their shareholding.

Vectura is a developer and manufacturer of inhalers and is listed on the British AIM exchange. The company received a takeover offer from American private equity firm Carlyle Group, before Philip Morris, best known for its global tobacco brands, trumped the offer.

The board of Vectura later convened, and recommended shareholders accept the offer from Philip Morris. This led to widespread condemnation of the board from the healthcare community, urges to shareholders to reject the offer, and even a demand of the British parliament to block the takeover. Threats have also been made to blacklist the organisation from scientific forums if the takeover is successful. So far, no offer has been made from these groups to actually purchase the shares themselves.

Philip Morris, for its part, says the acquisition is part of a strategy to diversify away from its traditional business. Like other tobacco companies, Philip Morris has been under pressure from its largest investors to develop a strategy outside of tobacco sales. Some observers would see the strategy as a way to profit from treating a condition actively caused by its products. Others may see it as a business seeking a future away from a dying product. Jeers or applause will vary based on perspective.

Irrespective of one's stance, it does raise an interesting point regarding risk.

Biotech and pharmaceutical development companies are notorious for being hit-or-miss, not dissimilar in this aspect to the oil and gas sector. Although biotech companies can be enormously successful, the reality is that the overwhelming majority fail, either due to ineffective treatments and trials, cashflow issues or simply being too slow to create a product when racing a competitor to market.

This high failure rate is one of the main reasons why private funding is so common in this sector, especially in the latter stages. 

But does investing in a pharmaceutical company carry an additional moral obligation not found in other sectors? While oil and gas companies are praised for diversifying away from fossil fuels and towards renewable energy, are tobacco companies precluded from the opportunity to change their business model?

The story will conclude next week, when shareholders – the group with financial exposure to the outcome – vote to accept or reject the offer.

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TRAVEL

Our Paraparaumu office is open. However, we ask that anyone wishing to see us in person first make an appointment by email or telephone, to allow us to prepare a safe and legally compliant environment.

Level Two does allow city visits, within sensible rules regarding each meeting.

Kevin will be in Timaru on Thursday September 30 (pm) and Friday October 1.

Chris plans to be in Christchurch the following week, after recovering from his surgery this week, which was highly successful.

His seminars planned for November will be discussed once we reach Level 1.  Chris hopes to be in Timaru, Christchurch, Nelson, Wellington, Kapiti, Palmerston North, Napier, Tauranga, Auckland and North Shore.

Centres such as Hamilton, Dunedin, Blenheim, Masterton, New Plymouth and Whangarei will depend on client interest.

Clients are welcome to bring friends and family. Please advise by email if you wish to attend, where, and how many would be with you.

Chris Lee & Partners Ltd


Taking Stock 2 September 2021

 

MY warning last week to be cautious of mortgage trusts was prompted by a misleading advertising campaign that compared mortgage trust returns with the returns of a bank deposit.

That cunning strategy had been used by the worst financial product selling chains 20 years ago, when the likes of Money Managers were selling property syndicates and its awful First Step mortgage fund, triumphantly boasting that the projected returns were far higher than bank deposit rates.

The projected returns might have been superior, but the ultimate return of capital certainly was not!

So when First Mortgage Trust, based in Tauranga, began a recent campaign using the same strategy, it seemed to be wise to send a caution.

What followed has been interesting.

One of New Zealand's best business journalists is the Scotsman Tim Hunter, a pithy writer with decades of experience and a good memory. He deserves his wide audience.

In the National Business Review last week he compared mortgage trusts with the pre-2008 finance companies. The social media response was rapid and conveyed to me the message that the subject needed more discussion.

First Mortgage Trust, it must be said, has been a survivor, having had its fledgling years prior to the finance company sector collapse.

It has grown since then from around $100 million of retail deposits to a figure nearer $1 billion.

Because of its structure it sits outside some of the regulatory requirements of finance companies. Its disclosed information is not as helpful as I would like.

So here is a picture of it, a fair one, in my opinion.

Like all contributory mortgage trusts, First Mortgage Trust raises money from retail investors and lends it to people and organisations whose needs are not met by the banks.

Specifically it lends to property developers for short, sometimes renewable terms. It lends to them at rates much higher than bank first mortgage rates and often it charges additional fees. It may renew loans that delay their repayments. There may be renewal fees.

From the interest collected, but not the fees, it deducts its costs, deducts a separate management fee, and returns to investors the remaining interest received, currently about 4.75%, before tax.

Investors may withdraw at any time, forcing the trust to hold in cash perhaps $200 million to meet withdrawal requests.

So if $800 million of its $1 billion were lent at 9% and $200 million earned next-to-nothing, then the gross return, assuming zero bad debts, would be 7.2%, meaning its management fees and costs must be around 2.45%, a high but still credible figure. The gross return of 7.2%, minus 2.45% of deductions, creates the investor return.

The loan fees, which are not the same as interest, and are not shown, might be nearer 4%, if the fund were attracting the typical property developers, who would these days be paying at least 13% during the riskiest phase of their developments.

That would imply the owners of the fund are receiving returns of perhaps $30 million a year from their loan ''fees''.

Perhaps they discount the loan fees. I do not have the actual data. It does not have to be disclosed.

The ownership of the fund changed hands in recent years, with a group of men now owning the management rights, having paid an alleged $45 million to buy that right. The fund has grown rapidly and is now promoted heavily. The managers are doing well.

The new owners are said to be experienced in property development lending, having cut their baby teeth while working years ago with the likes of Equiticorp and Strategic Finance.

First Mortgage Trust has never defaulted.

Yes, we have been in an unusually buoyant property market in recent years, but its unblemished record earns a tick.

The fund has no capital, so must have a skill in sourcing reliable borrowers and collecting loans.

If it never defaults, even in downturns, it would be a great achievement, virtually, maybe literally, unique.

Those of us who have had long careers in financial markets could easily rattle off the names of allegedly skillfully-managed mortgage trusts that have defaulted. The reputable funds managed by Tower and National Mutual defaulted; the awful funds like Guardian Trust and Canterbury Mortgage Trust defaulted; the absolute shockers like Prudential, First Step, Burbery and Reeves Moses Investorcare destroyed investor money.

Multiple contributory mortgage funds run by solicitors have collapsed, some because of theft, some because of incompetence.

The finance company equivalents always claimed to have impressive capital but we all will remember the ''capital'' claimed by the likes of Bridgecorp, Lombard, St Laurence, Strategic, Capital & Merchant Finance, Dominion, MFS/Octavia, Hanover, South Canterbury Finance, Equitable & NZ Finance.

Their acclaimed capital was about as real as a seven dollar note.

The reality was the finance companies reported capital that did not exist, often claiming as ''capital'' retained ''profits'' from ''revenues'' that had never been, nor ever were, paid.

So it is fair to say that most finance companies were no better than contributory mortgage companies. It took the global crisis to shed light on those ugly people and companies.

Property development loans create extra risks because they can be repaid only if the development is consented, built, costs constrained within budgets, and finally sold at expected prices, within an estimated time frame.

Any interruption of any of these stages generally leads to a bad debt, especially if an incompetent or dishonest receiver gets control of the project.

If there is no capital to absorb the debt, the loss falls on investors.

If the owners of the fund have been siphoning off fat fees, instead of squirreling the fees to absorb future problems, the investors would have no protection when the property cycle changes.

My view remains that retail investors wanting to participate in property market returns would take much less risk for similar returns by buying units in the various listed property trusts, such as Precinct, Argosy, Property for Industry, Kiwi Property etc.

The very best property developers save their profits and fund each development with more equity, enabling them to keep control of their developments during the inevitable years of slow sales or market disruption.

They earn the respect of bankers, and they protect their creditors.

Ultimately they borrow at rates far lower than the rates paid by the more flamboyant developers, who are spurned by wise banks.

My conclusion: get advice before using contributory mortgage trusts or do your own homework thoroughly.

Mortgage trust returns are not comparable with bank deposits. The practice of using that comparison should be stopped by the regulators.

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THE Oceania Healthcare seven-year bond rate has been set at 3.20%, ensuring it will attract attention from investors.

Though bond rates are still relatively low, the uncertainties posed by the wide range of problems facing global economies does suggest that capital retention and some income will be an attractive option for many retail and wholesale investors, for a percentage of portfolios.

Oceania's model is based on quality housing and services for those of the retired sector that can afford the cost. It must be bearing extra cost, as it protects its residents from a Covid invasion, but like Ryman and Summerset it has plans for a long-term presence.

I expect its bond issue to be well supported.

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NEW ZEALAND is not the only small island that has had to grow its debt to help it ward off the economic effects of Covid 19.

Until Covid, my wife and I visited Malta for a summer sojourn each year for two decades.

It is a small country - two populated islands, total population half a million.

One of its business leaders has responded to my polite enquiry as to how it is managing Covid.

Currently 80% of the people are vaccinated. Nobody may enter or leave Malta without vaccination, unless they submit to a quarantine period. The island hosts each year around 10,000 secondary school students largely from Eastern Europe. The students brought the virus in a year ago. The new rules apply.

The government subsidises wages at the generous unemployment level if a company's turnover has fallen by 50% or more. It also pays the rent and electricity for such companies.

Twice the government has handed out 100 Euros to every adult to boost consumer spending.

Debt levels are higher, but still low by European standards.

The wealthy, controversial Prime Minister, whose mission was to stay in power and drag Malta into the 21st century, has gone, his power base undermined by alleged links to the businessmen who car bombed and killed a journalist who the business sector feared.

The new Prime Minister is 43, had been in the job only eight weeks when Covid arrived, and is seen to be progressive and regarded highly for his communication skills and leadership.

The opposition party is in disarray, outflanked by the relative success in keeping the economy intact. Unemployment is at its lowest level since records were kept. Wages are rising because of labour shortages.

Does much of this sound familiar?

It will be a day to savour when my wife and I arrive again at Luqa airport, hopefully in 2022, and hopefully with no heat waves scorching Europe.

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Johnny Lee writes:

WHAT a busy August!

Reporting season has concluded, a New Zealand household name may soon be departing from our exchange, three bond issues were announced from a broad spectrum of issuers and, of course, New Zealand has returned to lockdown.

Reporting season managed to paint a very bright picture of our economy, sending most share prices higher. Growth, in particular, is being rewarded. The likes of EBOS, Mainfreight and the retirement sector are sending our overall index to within a whisker of January's record.

Some of the results missed the mark. A2 Milk's result did not meet the low expectations already set following a series of negative updates. The company has made a series of one-off adjustments to manage its inventory in the face of falling demand from China. While A2 Milk remains profitable, the surging growth has stalled, prompting the company to conduct an internal review. Investors hoping for a result to restore optimism did not receive it. The company's cash reserve of close to a billion dollars will buy it time, but it must discover a new way to flourish in these conditions. The results of this review will be an important step.

Mainfreight's update yesterday, by contrast, only sent the stock further soaring. The share price briefly rose above $99 a share before settling back at $98. Every facet of the business is positively booming, across all regions the company operates within. It is a remarkable story of success, one that has been shared by investors in Kingfish, one of the listed Fisher Funds. Mainfreight is a large holding for the fund.

EBOS also saw another double-digit lift in profit while announcing two acquisitions and the construction of a pet food factory, bringing an external cost in-house and giving them greater control over a supply chain risk for the business. Such investments pay for themselves fairly quickly, and are typical of large, cash-rich businesses looking to squeeze extra value for shareholders.

I would contrast this strategy to stock buybacks, where a cash-rich company simply uses its money to buy back its own shares, inflating the share price, a tactic often employed by the finance sector to manage capital it considers ''excess''. As we have seen repeatedly over the past two decades, this is almost always reversed by capital raisings, at much lower prices, during the inevitable economic slowdowns.

For investors, the rising share prices on our exchange will prompt some to consider turning paper profits into real profits, by selling some of their shares. The decision to sell is often far more difficult to make than the decision to buy, especially in a low-interest rate environment where holding cash is unrewarded.

As prices rise, portfolios will tend to overexpose themselves to individual shares. Part of our role as investment advisers is to help manage these risks. Investment rules and regular reviews aid this process.

Clients wishing to discuss their portfolios are always welcome to contact us.

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ANOTHER trend developing on our exchange is a tightening of liquidity, as investment opportunities dwindle and cash reserves build. Z Energy's takeover – if it occurs – will further exacerbate this issue.

Kiwisaver is growing. The flight from term deposits, seeking higher returns, is not yet reversing. A Z Energy takeover, returning some $2 billion to shareholders, will undoubtedly need a home. What is needed – and what should be occurring – is new offers coming to market.

The expected Initial Public Offerings of 2 Degrees and Vocus (best known for its brands Orcon and Slingshot) should help alleviate this pressure. I imagine two profitable companies, with consistent and reliable revenues, producing sane dividends and avoiding terminal levels of debt, would be welcomed with open arms.

In this environment, it would be optimistic to ask that the shares be sold cheaply. Nor will they be sold until a pretence of aggressive growth – the telecommunications market in New Zealand has its established players, and making meaningful inroads against these companies has proven difficult.

The two are different. 2 Degrees is one of our three mobile providers, alongside Spark and Vodafone, although 2 Degrees has about half the market share (20%) of the two larger operators (40% each). Like Spark and Vodafone, it will be considering the best strategy in regards to the rollout of 5G around the country, especially in more remote areas.

Vocus competes in the broadband sector, which is dominated by Spark. Vodafone, Vocus, 2 Degrees and Trustpower have meaningful positions, competing on pricing, customer service and, increasingly, cross-selling of other products, such as electricity or streaming services.

These two particular companies will not appeal to all investors if they reach a decision on any IPO. The economic environment is not necessarily one where investors can exercise any degree of power in price setting. Some investors dislike investing into companies where the majority shareholder is an active seller. Over-enthusiasm can also lead to distortions, leading some to prefer to wait until after the listing has already occurred.

Nevertheless, we need more listings, and with asset prices this high, this may prove to be a win-win for both sides.

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TRAVEL

We have suspended our city visits due to the nationwide lockdown. We hope to reinstate these shortly.

Chris Lee & Partners Limited


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