Learning to cut it in the global market

By Paul Harrison

Thursday 8th April 2004

The New Zealand stock market is now a far better, safer place to invest your hard-earned cash than it was 25 years ago, writes Paul Harrison from Goldman Sachs JBWere Portfolio Management

The seismic events of market deregulation and the 1987 share market crash were pivotal points in the evolution of the investment landscape.

The fledgling recovery began with the surviving corporates picking up the pieces and refocusing on their core operations.

The privatisation of state-owned assets encouraged international investors to venture into the New Zealand marketplace and, once here, they set about changing attitudes in the boardrooms.

International corporates followed portfolio investors as capital flows across international borders increased.

Any management team that failed to deliver the returns of which a company was capable was liable to be replaced through takeover by multinational. Fletcher Challenge, Wilson & Horton, Goodman Fielder and many others passed on this salutary lesson to those who remained standing.

Almost 17 years on from the crash, the reverberations of which still echo with would-be investors today, it's worth looking back to remind ourselves how much things have changed.

In 1987 "biggest is best" was the guiding principle of the day. Almost 50% of the largest 40 companies by market cap were either investment vehicles or conglomerates generally huge, sprawling beasts with accounts of mammoth complexity.

Shareholders often had to rely too much on management rather than clear financial proof that strategies were enhancing the value of the company. In some cases they clearly weren't: the investment company would on-sell investments into its own subsidiaries, booking a profit on the way through.

During 1988 alone, a remarkable $10.3 billion of debt was issued to pay for the party of the year before.

Inevitably there was a shake-down and the number of listed companies fell from 539 in 1987 to 174 at the nadir in 1992 the rest were either taken over or forced to declare bankruptcy.

The crop of corps was scythed down: Chase Corp, Renouf Corp, Equiticorp, and Judge Corp were all once members of the top-20 listed companies.

Contrast this with today: the companies that survived commonly have a simple structure with one core business that management know inside out.

The old Fisher & Paykel empire covered an array of businesses loosely connected with the original Appliances business: from steel making to distribution of electronic devices and even retail sales.

In the new world of open markets, it discovered they could buy the inputs to their products from those with greater economies of scale for far less than they could possibly make them.

Gradually, management identified the areas of the business in which they have real competitive advantage, be it superior technology, a smarter research team or better production processes. They sold off the businesses that had none of these characteristics and ultimately split the remaining businesses apart, creating Fisher & Paykel Healthcare and Fisher & Paykel Appliances.

Likewise, Fletcher Challenge was split into "letter stocks," where investors bought the segregated cashflow from specific divisions, and finally into separate companies.

Thanks to these changes, and much more transparent accounting practices generally, shareholders have a much better understanding of what the companies are doing with their money.

What caused this metamorphosis? Much of today's maturity has come about thanks to the involvement of institutional investors, whose larger shareholdings allow them to exercise more sway with boards than individual retail investors.

US investors were originally attracted by the economic restructuring New Zealand underwent and the IPO of Telecom New Zealand in 1991 gave them access to a company of a size they could effectively invest in.

The graph shows the dramatic increase in foreign ownership of New Zealand assets from 1990 onwards, albeit with a four-year slump after the 1997 Asian crisis.

Along with their money, offshore investors brought increasing demands for clarity in earnings reporting, corporate governance and returns on capital employed. Local investment managers quickly took up these themes.

They made sure boards of company directors and CEOs knew they would have to respect shareholder capital.

Money from shareholders could no longer be considered "free;" in fact it was to be treated as more expensive than debt, to compensate for the extra risk of equity investing.

This is no radical academic theorem: good housekeeping tells you that if it costs 12c to use a dollar for a year, investing that dollar in something that earns less than 12c a year will damage your wealth.

Growth in earnings per share (EPS) that is achieved by such "sub cost of capital" investment is counterproductive. That is why EPS growth is a poor predictor of value (as represented by the price to earnings multiple).

The correlation between the two in Australia in 2000 was approximately zero (above 70% indicates reasonable predictive power). This means basing corporate decisions around achieving EPS growth is unlikely to be a successful strategy. The question that should be asked is "Will the growth make the company more valuable?" The answer was a resounding "No" for several expansion projects launched by New Zealand companies in the 1990s.

Fletcher Paper struggled with its ill-fated acquisition of UK Paper, which led to more than $1billion in equity being written off. Air New Zealand famously had to be bailed out by the government when Ansett collapsed. Growth is not bad: growth for growth's sake is bad.

Fletcher Building is a good example of a business in the process of transformation. It sold businesses in which it was unable to generate adequate returns and is growing instead in areas where it has a crucial competitive advantage.

Last year it generated 2c for every $1 invested. This is "good growth" and it is for that reason that it is one of the core holdings in the Goldman Sachs JBWere Portfolio Management portfolios.

Corporate governance (the method of internal checks on management) has also been improved since the crash. Ontario Teachers' Pension Plan, owner of 11.6 million Telecom New Zealand shares, when asked why it cared so much about corporate governance, replied, "Because it affects the long-term performance of the companies in which the fund invests and when practised effectively yields better, more transparent disclosure and greater management accountability."

What proof is there that the added discipline demanded by investors has benefits for the company? Stern Stewart & Co is a consulting firm that has pounded the table about the need for capital discipline.

Its study in the US showed that those firms whose decision-making is based on "economic profit" (profit after accounting for equity costs as well as the interest on debt that is included in "accounting profit") achieve an 8.3% a year better average share price performance than less enlightened peers.

A clear positive relationship between better stewardship of capital (ensuring that each additional dollar of investment earns an adequate return) and share price performance can be seen in the chart on p24, the output of a study of the telecoms industry based on the Stern Stewart methodology.

Stern Stewart noted in February this year that New Zealand's best performing company on this measure is Sky City.

Its share price performance up to Dec 31st 2003 shows that "the market has not only rewarded (Sky City) for its ability to generate economic returns in the current period [ 81c of value created for every $1 invested] but also for its likelihood to continue creating similar economic returns into the future." Therein lies the rub: it is imperative to maintain capital discipline to secure continuing market support.

So, from being a share market dominated by speculative investment companies, property companies and complex conglomerates, New Zealand's companies are now run by managers and directors who have learned that an acceptable return must be made on the capital entrusted to them and who understand the importance of good corporate governance.

New Zealand is a far better place to invest these days than it was back in 1987.

Comments from our readers

No comments yet