Share prices don't tell the story of the economy

By David van Schaardenburg

Friday 7th July 2000

EQUITY RETURNS

To June 30, 2000	July '99-June '00	July '98-June '99	July '97-June '98

NZSE40 (incl divs)	2.9%	7.1%	-17.4%
Telecom (incl divs)	1.6%	12.1%	13.6%

Does the front-page headline in the New Zealand Herald on June 27, "Growth spurt best since 1995 boom," indicate things aren't as bad as the pessimists might believe? Or does a look at yesteryear's economy provide little indication of future economic prospects?

The economic growth statistic used in the comparative by the Herald (+4.4%) covered the period from March 1999 to March 2000 and compares with economic growth in the two preceding annual periods of 0% and 1.9%.

But by the time Statistics New Zealand grinds out economic growth information, time and economic trends have moved on. While on the surface the latest economic growth statistics give the appearance of a positive trend, since March 2000 a number of forward-looking indicators present a more gloomy picture.

The net business confidence index has declined from +26 in March to -55 in June (National Bank monthly survey of business confidence) while the quarterly WestpacTrust/McDermott Miller consumer confidence survey released on June reflected a decline of 16%.

The broad equity market has performed well below economic trends. While one might expect shares as an asset class to underperform their presumed average return level of approximately 11-12% while economic growth tracks below an "average" level of say 2.5%, it is somewhat surprising to see a continuation of below average share returns when economic growth is spurting to supposed "boom" levels.

What are the reasons for this divergence between economic and equity market performances in recent years? Factors such as:

differences between NZSE40 industry weights and New Zealand industry weights (for GDP growth calculation purposes);
the forward perspective of equity investors compared to the historic nature of economic statistics;
the variance between share price drivers and company fundamental drivers; and
the corporate profit trend variance from economic direction (for example, the impact of increased competition).

One example has been the performance of Telecom. By a considerable distance (27% weight compared with the second largest at 6.7%), Telecom has the largest weighting in the NZSE40 index. Its return trend can be expected to strongly influence the return track of the NZSE40.

Telecom's price has fluctuated between $7.30 and 9.80 over the last three years (now $7.50) while consistently paying an annual dividend yield of about 5-6% (100% imputed). Volatility in Telecom's price appears to be driven primarily by the:

perception of the level of future industry competition and regulation;
costs of its Australian expansion plans;
market reaction to senior management transition in 1999 and consequent results;
flattening profit growth profile; and
relativity with other telcos globally.

In fact, not much of Telecom's fortunes appear linked to New Zealand's economic growth trends. Like many larger Kiwi companies, how the company stacks up in a global context and its offshore business plans appear more important to investors.

If these observations are correct, the importance of active New Zealand equity portfolio management via a more bottom-up rather than top-down emphasis is accentuated. Proof of this will be a comparison between active manager performance and that of the market indices (presuming most active managers have a bottom-up emphasis).

For the three years to March 2000, active New Zealand equity manager returns (from the 13 firms surveyed) averaged 7.8% per annum before tax and fees above the market index return, with the average excess return being 10.1% for the year to March 2000.

In fact, all active New Zealand equity managers surveyed surpassed the index return over both the one- and three-year timeframes.

In conclusion, wherever the economy goes don't expect a similar trend in either the share performance of many of the main listed companies or indeed the returns of active New Zealand equity investors.

Also, as a market, active New Zealand equity portfolio management does pay dividends but an indexing strategy may be a formula for failure.

These conclusions offer a glimmer of hope to active New Zealand equity investors amid an increasingly gloomy broad economic outlook.

David van Schaardenburg is general manager of Ipac, an investment strategy and funds management research company

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