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Bottom feeders

By Roger Armstrong

Sunday 1st June 2003

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The government is trying to keep us safe from bad investments. It has given the Securities Commission sharper teeth, required better disclosure by companies, toughened up the rules on inside traders and is bringing in tighter controls on investment advisers. All good stuff, if a little over the top in some areas.

But the reality is that the best protection for investors lies in not disengaging the brain from the hand when signing the application form at the back of a prospectus. Government laws can't protect people who give their money to fools, chase the latest bubble, invest in companies where others get favoured treatment, or believe overly optimistic business plans.

New Zealand's share market often gets labelled with the "the wild west" tag as a result of what happened post the 1987 bust. Yes, some shoddy practices came to light back then - fuelled not by pure evil but by the optimistic euphoria of the 1980s bull market. It didn't help that egotists and incompetents ran some of our biggest companies, and that accounting and disclosure rules were lax. But the main reason money was lost was because of bad investments and excessive gearing, which left punters over-exposed when asset values headed south.

In other words, investors lost their shirts primarily because of their own lack of judgement, poor research and greed.

Since the harsh lessons of the 1980s, the behaviour of mainstream listed corporates has been pretty good - with exceptions such as the overblown prospectuses of Wakefield and Vertex. Overall though, the excesses seen in the US with Enron, Tyco and WorldCom make New Zealand corporates' integrity look exceptional.

But don't start feeling too smug and safe; New Zealand still has an investment wild west. It's in the small companies market - on the Unlisted Securities Market (USM) facilitated by the NZSE (these shares are quoted on the broker-to-broker screens but are not subject to any stock exchange listing rules), on the exchange's own disaster area the New Capital Market (where startup companies can raise capital), and in stocks which are not quoted at all.

When it comes to investing in prospectus issues for companies that are not mainstream stock exchange listings, punters need to be super-sceptical.

One reason is that these smaller company floats are not normally exposed to the intense scrutiny of experienced investment bankers and professional investors. The major investment banks tend to steer well clear of them. For a start, these guys don't generally sign an engagement letter for less than $250,000 - more than the entire budget for most small company new issues. Second, they are naturally wary of the risks to their reputations of dealing with small companies that don't have the history, depth of professional talent and systems to ensure smooth sailing.

Private investors probably don't appreciate the filtering, vetting, structuring and, importantly, pricing work undertaken by major investment firms such as ABN Amro, CS First Boston and USB Warburg before they bring a new company to market.

Because larger floats are intended for the sophisticated institutional market, investment bankers know to discourage the vendors of such companies from adopting any tricky capital structures in their favour, or handing out any soft option deals to themselves.
For private investors, this means the principle of "buyer beware" is even more important than with larger floats. No amount of government legislation or Securities Commission vigilance will protect investors from a bad issue. The best protection is a highly tuned bullshitometer and reading the prospectus top to tail.

The number of small companies seeking money by prospectus but without an intention to list seems to be increasing. The pitfalls are huge.

Last year health and safety software company Intaz raised money at $1 a share. Its shares are now quoted on the Unlisted Securities Market at 18 cents. After adjusting for a 1:1 rights issue at eight cents that's about a 70% net loss in a year. Yet a cynical read of the prospectus should have alerted investors to the danger. Shares had been issued 18 months earlier at 35 cents - so why the difference? Revenue was forecast to grow from $500,000 to $86 million in four years - hmm. Some soft options were issued to management and directors qualified for rights issues - a no-go zone with many institutional investors due to the value that can be scalped off ordinary shares when there is a rights issue. (And the company has subsequently had a heavily discounted rights issue, surprise surprise.)

Christchurch electronics firm Connexionz, the developer of a real-time passenger information system for public transport networks, is another example. It tried to raise $4.5 million through a public offering last year, managed to raise only $1.5 million, but still went ahead with the issue. It is now trading on the Unlisted Securities Market and the shares are selling at 89 cents, compared to the $1 issue price. Given that the company was trading at a loss this partial fundraising hugely increased the risk to investors, bringing into question the decision to proceed.

Last year Aids researcher Virionyx raised $7 million off the public at a price that implicitly valued its intellectual property at around $180 million. At a time when Genesis was trading at levels that valued its intellectual property at close to zero, the Virionyx capital raising was a triumph in marketing. An Aids cure sounds enticing but it is a crowded and competitive field of research. It is unlikely a major investment bank would have promoted, let alone underwritten, a float at this sort of pricing level. Investors will do well if Virionyx finds a cure to Aids, but they almost certainly paid too much relative to biotechnology pricing around the world at the time. In the meantime, the company is not quoted on any market, so valuation remains subjective.

At the time of writing there are at least two current prospectuses for unlisted securities.
ProTen is a chicken farmer looking to raise $10 million and take on the Australian industry in an ambitious business plan. The company produces chickens on contract to Tegel. It's a tricky industry in which to make decent returns, due to the nature of the contracts with Tegel and other brand owners that say contractors can effectively be sacked with relatively little notice, making it easy for other growers to move into the market. This suggests chicken farming is a venture more suited to the owner-operator than a public company.

CeAnic is looking to raise $20 million to invest in the "marine industry", which apparently is a catchall term for such diverse businesses as boatbuilding, aquaculture, marine financing, software development and marine energy generation. It's hard to see a major investment bank bringing such a business plan to market. In addition, the float involves the issue of eight million "founder shares" to certain individuals in return for 20% of the shares in a number of marine-related companies. The shares can be redeemed for cash in 2008, a possibility that implicitly increases the risk profile for ordinary shareholders.

Forgetting the issue of size, the two new companies mentioned above would have had trouble convincing major investment banks to put their business plans in front of their client bases.

The risk in the current government zeal for securities market legislation reform is that the lessons of personal responsibility get lost - that people will feel so snug and safe inside the regulatory straitjacket of continuous disclosure and heightened Securities Commission monitoring that they forget the principle of "caveat emptor".

At the bottom end of market, they do so at their peril.

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