Taking Stock 25 July 2024

IT MAY be the tight mesh of the safety nets created by regulators, or it may be the global desire to pretend that excellence is not a desirable goal.

Whatever the reason, two of the most obvious changes to have occurred in my 50-year career in financial markets have been the encouragement to invest in index funds, and the recent trend to direct money into private equity funds, rather than into banks or listed securities.

The deluge of money into index funds probably is linked to the general willingness to accept an average outcome, and the desire of financial intermediaries to be free of regulatory scrutiny.

If funds base selections on research, and seek to differentiate the excellent from the mundane, the market gets real price discovery.

The active manager sets what he believes is the right price for the prospects of the companies he chooses.

If all transactions come from index funds, then prices would be set solely by the volume of money, reflecting supply and demand. Momentum would create prices, no matter how nonsensically.

The index fund manager pursuing a bit of everything will never be prosecuted for missing good signals, nor blamed for missing poor signals. He will own Infratil. He will own Air New Zealand.

The world's investors have increasingly voted to accept the “average” rather than trust research to uncover the potentially excellent and eliminate the weak. The regulators like this.

The move to private equity seems at odds with the logic of the trend to use index funds.

Private equity is virtually unregulated and has minimal transparency, minimal accountability, yet it now attracts trillions of investor dollars. (I cannot be specific as estimates vary between 3 trillion and 13 trillion, too wide a gap to offer useful guidance.)

The private equity funds do not offer to “mark to market” as there is often no market available, upon which to “mark”.

These funds do not offer liquidity. The funds will sell their holdings when they choose.

These funds engage with their chosen valuers.

Is it unfair to query the process of choosing the most careful valuers, the most optimistic, and even to wonder whether valuer fees are linked to their willingness to accommodate the opinions of the private equity managers?

The one certainty is that private equity managers are growing at breathtaking speed, gradually funded by pension funds and other fund managers wanting to step aside from “mark to market” disciplines.

By definition, private equity funds can take long-term investment horizons, higher returns eventually resulting from long terms.

And, by definition, private equity funds can take the higher risk strategy of buying illiquid assets at times when the assets might be out of favour.

The American private equity bid for the care provider Arvida, announced last week, is an example of how long-term investors with no defined horizon to achieve a result can buy assets they perceive have more value than that ascribed by those suffering from short-termism, such as most of our Kiwisaver providers.

The Americans clearly see replacement value and future cash returns as being far more valuable than most of our investment managers recognise.

Private equity is just as adventurous when it enters the money lending game, often funding leveraged buyouts, or second tier corporates.

Often private equities offer “light” covenants, seeking higher margins as an offset for the high risk of weak covenants.

If there is to be a day of reckoning for this adventurous approach, that day has not yet dawned.

Acting logically, the mainstream banks often are happy to lend to private equity funds, taking a prior security, meaning all pension fund money put into the private equity fund is subordinated behind the banks, effectively capital.

Are the returns for the investors sufficient to offset their “equity” risk? Hmm. We will see.

The takeover of Arvida is clearly a recognition that if you accept long-term success, you must put aside short-term objectives, like dividends and liquidity.

The asset backing of Arvida was about double the price of its shares, few NZ fund managers wanting to be patient (Harbour Asset Management and Milford the obvious exceptions).

Recall that just a few years ago the Swedish bought Metlifecare from the NZ shareholders, also taking a long-term view, knowing its Swedish funders would be patient.

The late Brian Gaynor often warned that the short termism of NZ fund managers threatened investors, leading to impatient sales at ugly discounts to perceived long-term value.

There seems little symmetry between the flood of money going into index funds, where the investment horizon is set daily, quarterly results the first measurement of success; and the flood into private equity, where lack of transparency, lack of regulatory support and a focus on very long-term results is the objective.

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THE population of Malta, around 550,000 not including tourists, is similar to the Greater Wellington area.

Malta has two excellent daily newspapers, costing 1.3 euro, or say NZ $2.50.

The Times of Malta is printed in English and in Maltese, typically it comprises 24 pages of which six are dedicated to the national news, six to world news, two to chatter (letters to the editor etc.), four to business news, four to sport, and two to a range of puzzles.

The national news is relevant, indeed riveting.

 For example, the paper at which I am looking as I prepare this item has a half-page article on the changing levels of Maltese students’ success in O level maths and English.

It highlights that 20% of students fail in these subjects. More than 40% of students received A levels, while 14% failed to pass.

Of those who sat advanced maths 20% failed to pass.

I record all of this to highlight the relevant detail of a subject that would greatly interest parents, grandparents and, of course, students in any country which places emphasis on education. This information is what I want to read in newspapers.

Maltese absenteeism is low, though during Covid that became a concern.

The paper's coverage of global events is excellent. Those who enjoy reading entertainment pieces about “celebrity” media people, or about broken marriages and the subsequent miseries of punctured tyres, sick pets and unpleasant neighbours would find the Maltese papers rather plain.

Such magazine content is absent from the papers I read each day while in Malta. I do not miss such dross.

Does the fact that two papers can succeed with a modest circulation and very little advertising indicate that content matters?

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AN array of summarised items I found interesting follows: -

- Britain proposes to place VAT (tax) on private school fees.

- It proposes to increase its windfall tax on North Sea oil producers from 35% to 38%, meaning total tax on North Sea profits will be 75%. Producers observe that capital for exploration has ceased. The North Sea produces 50% of Britain’s oil and gas and employs 200,000 people.

- In 2013 one in 90 British 18-year-olds vaped. Today the figure is one in four.

- Moodys (credit rating agency) has placed 21 US regional banks on review for a credit downgrade because those banks have commercial real estate lending volumes greater than twice their capital.

- Europe's Stoxx 600 share index is at an all-time high, with the expectation of earnings increases. Conversely the economic outlook is said to be deteriorating. Disconnection?

- Labour Government in the UK plans to build 1.5 million new homes in five years. Britain has 43,000 bricklayers. Three quarters of them are at or near retirement age. Britain will train 33,000 new bricklayers to enable it to build 1.5 million new homes.

- Britain limits welfare to families by stopping extra payments after funding two children. Voters support this two-child cap by a margin of 2:1.

- Bankrupt UK council Croydon is to implement a new tax on companies that provide more than 11 car parks for those of its workers who drive to work. The tax will be paid by the workers. Four other councils propose to follow this lead.

- When the recent internet outage occurred, the cause of the error, CrowdStrike, saw its market capitalisation fall from NZ$130 billion to $110 million in one day.

- Necessity leads to invention. Massive new 100-metre-high wind turbines are much more efficient, and have a lesser carbon footprint in their manufacture, than two 50-metre high turbines. But transporting such monstrous machines is a problem. They are too big for bridges, tunnels, and most roads. 

So an American company is building a massive cargo plane to transport the turbines to their destination. The plane will be around 110 metres long and will be able to land on, and take off from, dirt tracks. The first plane will be in service in 2030.

- For the first time ever VW will close a European car manufacturing plant rather than reduce shifts, or reduce margins to compete with Chinese imports. Europe responds by discussing tariffs. Internal combustion engines and hybrids have reversed their market share losses in recent months. 

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New Investment Opportunity

BNZ - Perpetual Preference Shares

Bank of New Zealand (BNZ) has announced that it is considering making an offer of perpetual preference shares (PPS).

The PPS are expected to constitute Additional Tier 1 Capital for BNZ’s regulatory capital requirements and to have a credit rating of BBB.

This investment is perpetual, with an optional (and in our opinion likely) redemption date in six years’ time.

The initial six-year distribution rate has not been announced, but based on comparable market rates, we are expecting a rate of around 7.00% per annum.

BNZ will be paying the transaction costs on this offer; accordingly, clients will not have to pay brokerage.

More details are expected on 5 August.

BNZ is one of the top four banks in New Zealand and a subsidiary of National Australia Bank. It has a strong credit rating of AA-.

If you would like to be pencilled in on our list, pending further details, please contact us promptly with an amount and the CSN you wish to use.

Indications of interest will not constitute an obligation or commitment of any kind to acquire this investment.

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Travel

26 July – Timaru – Fraser Hunter

25 July – Auckland (Ellerslie) – Edward Lee

26 July – Auckland (Albany) – Edward Lee

1 August – Wellington – Edward Lee

21 August – Christchurch – Johnny Lee

Please contact us if you would like to make an appointment to see any of our advisers.

Chris Lee and Partners Limited