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Ratings reduce hidden risks for investors

By Patrick Caragata

Friday 5th September 2003

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The behaviour of many investors and speculators in New Zealand is often not based on sound knowledge of a company's financial fundamentals, nor is it based on careful scrutiny of the level of risk relative to potential returns.

Most investors seem to chase returns with scant knowledge of the levels of risk they are embracing. This problem stems from several causes:

  • many investors have not learned the lessons of previous market collapses;
  • a lack of scientific analysis of corporate financials and corporate risk ratings in the market;
  • investor impatience and fear of being left behind;
  • investors' inability to understand and successfully interpret company financial statements; and
  • investors' related inclination to focus on brand name and reputation as the basis for reaffirming their decision to chase the "rate of return" as the only objective.
  • Based on its software-driven rating criteria, Rapid Ratings rates Telecom New Zealand as the best quality investment grade company in the NZX50 (Table II), followed in second equal place by Telstra and Auckland International Airport (AIAL).

    F&P Healthcare is tied for fourth with Sky City and Restaurant Brands. Ports of Auckland is rated seventh best, while Westpac, Fletcher Building, Mainfreight and Port of Tauranga are equal eighth best. ANZ and Steel & Tube are tied for 12th place. Only seven percentage points separate Telstra from ANZ Bank, so the race among the top 12 rating positions is very tight.

    The companies that are generally rated the highest by Rapid Ratings have been consistently very good to excellent over a long period of time. At the top end, the companies on the NZX (Table III) that have been rated consistently high by Rapid Ratings (generally B1, A4 or A3) have been Telecom, Telstra, AIAL, Sky City, Ports of Auckland, ANZ Bank and Westpac.

    Some unlisted companies, such as Bank of New Zealand, UDC and National Bank of New Zealand, are just as highly rated as these companies. Attaining a rating of A1 or A2 where a company is operating at 90-99% of its potential relative to a global reference set is uncommon.

    Biggest improvers

    The companies with the most improved rating for the most recent financial year are F&P Appliances, Nuplex, NGC Holdings and Restaurant Brands. Companies exhibiting the best long-run improvement relative to their low point in recent performance are Fletcher Building, Nuplex, Steel & Tube, Wrightson, F&P Appliances, Lion Nathan, NZ Refining and Carter Holt Harvey.

    The best investment grade companies (consistently B1 or better, combined with stable or positive outlook) are AIAL, ANZ, Sky City, Telecom, Telstra and Westpac. Companies undergoing or which have undergone major declines in the last five to seven years are Tranz Rail, Air New Zealand, Fletcher Challenge Forests, BIL, AMP, Tourism Holdings, Contact Energy and Tower.

    Only 40% of the top 50 NZX companies are investment grade, and 55% are either investment grade or borderline investment grade. There is a significant difference in the level of risk from the top to the bottom of the investment grade category.

    Telecom is rated as A3 and is operating at 88% of its potential based on a global comparison with companies in the transportation and communications industry. It is performing 29% better than Axa, which is at the bottom of the investment grade category. Axa is performing 300% better than BIL, which is at the bottom of the top 50 along with Fletcher Challenge Forests.

    Rating surprises

    Company size and brand name do not guarantee good quality performance or a sound financial position. Rapid Ratings does not hesitate to downgrade a company to junk bond or sub-investment grade status if the company is showing significant deterioration.

    Likewise, a former investment grade company that had been performing poorly and which has undergone a major restructure can regain its lost investment grade status quite quickly if it makes the right decisions.

    Some companies may have higher leverage and/or depressed earnings as a result of transfer pricing manipulation, thin capitalisation and the payment of heavy royalty and management fees and, as a result, will receive a lower rating from Rapid Ratings than would otherwise be the case.

    Hence, a company that strives to maximise its tax benefits within the law may suffer in term of its rating, as well as its share price and possibly its cost of capital. Likewise, a company that pursues capital gains at the expense of operating profits may also have a lower-than-expected rating.

    Dr Patrick Caragata is the founder and managing director of Rapid Ratings, a software-based global corporate credit rating agency operating in New Zealand, Australia, Europe and North America. © All rights reserved. Rapid Ratings 2003.

    Rapid Ratings accepts no liability whatsoever for any direct, indirect or consequential loss of any kind arising from the use in any way of any information in this article. The ratings are independent opinions of risk and not an offer to trade in securities.

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