Taking Stock

Read the latest Taking Stock

Johnny Lee writes:

Capital gains tax appears to be off the table, for now.

The shelving of the proposed capital gains tax has matched our expectations. The group which by the majority recommended the tax did not offer the sort of analysis that might have swayed the electorate.

Following an announcement on Wednesday afternoon, the Labour-led Coalition Government have stated they will not implement a capital gains tax while the current Prime Minister remains in that position.

While property owners and shareholders will be pleased to have certainty in this area, it is difficult to isolate a winner from this process, other than the tax working group members themselves, whose expertise has largely been disregarded. It has been suggested that some of their work could form the basis of another working group, sometime in the future. One lesson such a working group could take from this saga, is that needless politicking from members of the group create unnecessary and unhelpful distractions to the process of politicians presenting important ideas to the public.

Overall, the process feels like a waste of both time and money. One would hope that the data collected and research conducted is put to use in some capacity, if perhaps only to serve as a reminder that democracy usually favours the majority view of the public.

Without wanting to delve too far in to the politics of the decision, I suspect that their inability to implement the recommendations made, suggests the tax treatment of capital that is currently enforced is unlikely to change. Both sides of the political spectrum seem to believe the current approach is right for New Zealand.

Investors can have confidence that the current tax regime for capital is here to stay.

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Any doubt that interest rates will be cut this year appear to have been put to bed, as inflation data released this week suggests the expectation of a cut in the next few months, likely followed by a second cut later in the year, is justified.

Quarterly inflation was up only +0.1% for the quarter ending March, and would have been -0.1% had the tax on tobacco products not increased its price. A number of factors led to this, including falls in the petrol price and in the cost of international travel. Petrol prices have rebounded somewhat, but with inflation well outside the Reserve Bank’s band, it seems likely that savers will be subjected to further cuts in interest rate returns in the months ahead. The New Zealand dollar also fell, as markets further priced in the likelihood of lower interest rates.

The Reserve Bank’s inflation mandate targets a medium-term target inflation rate of 1-3%. Using the small number of tools at their disposal, they are tasked with manipulating consumer expenditure to drive towards this outcome. As Mike has previously touched on in Market News, these small number of tools appear to be seeing a reduction in their efficacy, which may prompt the Government to either introduce new tools for influencing inflation, or to directly affect it by changing levels of Government expenditure or taxation.

With the budget only a month or so away, the Government will have the opportunity to reflect on its current trajectory and evaluate whether a change in approach is warranted. One outcome they will want to avoid, is for inflation to continue to fall.

Sustained deflation, or falling prices, can be destructive to economies, though not as damaging as the hyperinflation currently being experienced in some of the worst economies in the world. Deflation causes people to reduce their expenditure (with the expectation that the same item will be cheaper the next day). This causes producers to supply less, which reduces employment, further reducing consumption. Deflation also causes the fixed value of debt to increase, making it more difficult to service.

New Zealand is not yet at a point where deflation is an issue that necessitates a response, and it seems doubtful that lowering interest rates would dramatically impact that regardless. Once interest rates reach ultra-low levels, you encounter additional problems, such as savers withdrawing money from banks. Today, Term Deposits continue to offer rates in excess (barely) of 3%, leaving the retail banks with room to manoeuvre if interest rate cuts are made later this year.

These interest rate cuts come at a time when more funds continue to pour in to companies listed on the stock exchange, causing its index to challenge the 10,000 level that has been threatened several times this year already.

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It is important to remember that our index is a gross index, a term that allows it to include dividends. A gross index assumes that all dividends are reinvested back in to the stock, so as to provide a better reflection of how the constituents of an index are actually performing from the point of view of the investor. As New Zealand companies tend to pay a higher proportion of their profits out in the form of dividends, a gross index was judged to be a more appropriate method of comparing the performance of our listed companies.

Other common indices, such as the S&P 500 in the US, tend to use the capital values excluding dividends.

New Zealand’s history with this methodology has produced incremental rises, year by year, with the inclusion of dividends boosting the index, similar to the effect of compounding interest.

Prior to 2003, New Zealand used a capital index, measuring simply the performance of each share price regardless of dividends. This meant that if the share price of ABC Limited was $1, and paid an 8 cent dividend to return to a share price of 92 cents, the methodology deemed that the index had fallen. New Zealand shares tend to pay higher rates of dividends than their international peers, meaning such a method would be an ineffective tool for comparing itself internationally.

In 2003, the New Zealand Stock Exchange decided to changes its methodology to using a gross index, so as to better reflect the return investors received when purchasing shares on the NZX. Commentators at the time believed that the leadership team within the NZX were inspired to make this change to rebut criticism of the New Zealand markets performance under the capital index methodology. Certain investor groups at the time argued that these changes made it a less useful benchmark when comparing their own performance to the index. Cynics even pondered the impact of index changes on capital market bonuses!

There is no one perfect approach when using these tools, but it is important to remember that when comparing our market performance to our international peers, that the apples and oranges are sorted correctly.

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Edward Lee writes:

Last week, I attended the Infratil investor day presentation to hear how the Infratil portfolio has evolved over the past 12 months. As usual, I was impressed with the Infratil management team, who articulated themselves well, proved extremely knowledgeable about the sectors that they had invested in, and were excited about the future prospects of the various businesses held within the

Infratil portfolio.

Over the past year, Infratil has sold a number of its income producing assets to simplify its portfolio, which has led Infratil to becoming more concentrated on a small number of growth companies. Assets that have been conditionally sold include NZ Bus, Snapper and ANU (Australian student accommodation). Perth Energy is also up for sale. Reading between the lines, I got the impression that the retirement business in Australia (Retire Australia) may also be up for sale at some point in the future. Additionally, Infratil made it clear that it would like to invest in the renewable energy sector in Europe.

So out with the old, and in with the new. Cash generating assets have been reduced from four companies down to two (Trustpower and Wellington Airport) and will likely stay at two for some time.

With the recent purchase of 65% of Tilt Renewables (and the investment in Longroad) the portfolio is now heavily concentrated towards the renewable energy sector (48% of the portfolio). New Zealand based investments have fallen from 61% to 50% of the portfolio, and this shift may put the imputation credits at risk.

Infratil has previously been viewed as an income producing company, with an excellent retail bond programme, and a share that has paid reasonable dividends. Its shares have always traded at a discount to Net Tangible Assets and will likely always trade at a discount. However, it became clear to me that Infratil was preparing investors for the inevitable. As the income producing assets are sold, and the number of growth companies within the portfolio increase, dividends may not be as strong, and imputation credits may reduce. Growth companies often find themselves in need of capital, especially during their formative years.

Infratil made it clear throughout the meeting that it would prefer its business to be viewed as a growth company, rather than an income producing company. With the transition of the assets into more growth type assets, and with Wellington Airport likely to hold back some capital/retained earnings for its own growth plan, there will not be as much cash available to continue the trend of rising imputed dividends.

As the portfolio of assets shift towards this approach, one item that will clearly need to be addressed is the now inappropriate management contract with Morrison and Co. Currently, Morrison and Co receive at least three different management fees for the international portfolio. These include initial incentive fees, annual incentive fees and realised incentive fees. There is a high hurdle of achieving a minimum of 12% per annum after tax return, however the 20% “outperformance” fee is enormous and has led to an extra fee for the year of $100m off paper valuations rather than actual realised profits. I will let that number sink in for a bit. One Hundred Million Dollars, a life changing amount of money.

One cannot argue that Infratil hasn’t performed well over the past 12 months. Its share price has performed well, mainly due to the ‘Canberra Data Centres’ which Infratil hopes will likely continue its growth trajectory, and through the realisation of the assets at values above book value. However, with this transition towards more international assets, along with the transition from income producing assets in to growth assets, the incentive fee of 20% should be reviewed.




Edward will be in Tauranga 29 April.

Kevin will be in Ashburton on 9 May.



Johnny Lee

Edward Lee

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