National Mutual throws out the crystal ball
National Mutual has developed a set of leading indicators to help it predict future market trends.
Monday, April 26th 1999, 12:00AM
We would all like to be able to predict the future. No longer would you be left carrying an umbrella on a sunny day but more importantly you would be very well off financially. Investing with the benefit of hindsight is easy but it’s the future that counts.
At National Mutual we have constructed a range of leading indicators. These tools help us to anticipate what should happen in the future given what has occurred in the past. Investment strategist Darryl Briggs has developed a variety of leading indicators which are proving of considerable assistance in our decision making process. With the aid of significant computer power and a large database we can identify the factors that drive changes to the economy, various industrial sectors, individual company share prices and the financial markets as a whole.
Our analysis depends upon successfully identifying those factors which lead or drive changes and dismissing those that lag. For example, the unemployment rate has only limited explanatory value because it does not lead changes in economic activity or GDP. Changes to the unemployment rate follow changes to activity levels in the economy. As the economy improves so unemployment naturally falls. By way of contrast, interest rates do provide a lead as to what might happen to the economy in time. If interest rates decline, the cost of servicing a mortgage declines and eventually new house building will pick up as a consequence. In fact, our modelling shows that is exactly what happens although, to be fair, interest rates are not the only factor impacting on new house building.
Let’s consider the building sector in more detail. The chart below shows the ups and downs of residential property investment in the New Zealand economy (as provided by the Dept of Statistics) over the past 10 years. It is clearly cyclical in nature. For equity investors, knowledge of the residential building cycle is important in order to effectively judge the near term prospects of, for example, the building material supply companies such as Fletcher Building and Steel and Tube Holdings.
The chart also shows National Mutual’s residential property investment indicator. This indicator is strongly correlated with or linked to the changes in residential property investment. It is constructed by combining and then weighting the main factors which we have identified as having a significant influence on new house building – 6 key drivers in all. The new house building industry should soon experience a strong upturn in our opinion:
- intuitively, because interest rates have declined and house affordability has improved;
- anecdotally, because buyer enquiries have picked up and architects report increased interest;
- technically, because our leading indicator, given its previous explanatory power, points to an imminent recovery.
Such a positive view has been reflected in the composition of the share portfolios that National Mutual manages. We are overweighted the building sector, in particular Fletcher Building shares, because we believe profits will improve strongly as the house building cycle strengthens. Our confidence in a recovery partly explained why we thought the recent Holderbank bid for Milburn should be contested. We considered that the price offered placed too much emphasis on the recent industry downturn and not enough on brighter returns in the future. Our resistance paid off because the independent expert’s final price represented a 19 per cent premium to the Holderbank bid price.
The Leading Indicators that we have developed in-house are increasingly influencing our stock selection. The indicators provide a very important top/down perspective. Our equity analysts are left to conduct, of course, the still important bottom/up equity analysis. For example, they continue to ask themselves such questions as is this a good company, well managed with a solid financial position and are its shares appropriately priced in the market?
We believe the substantial outperformance against benchmark posted by National Mutual’s Selected Equities Trust over the last year (+45.0 per cent before tax and fees versus the NZSE40 Gross Index of –0.1per cent for the year to March 31) reflects in part the contribution made by our increasing array of leading indicators. We are applying a little more science and a little less art to our management approach.
Our leading indicators are pointing to a meaningful domestic economic expansion over the next 12 months, solid growth in tourist arrivals and further increases in consumer spending. We are confident that the NZ sharemarket will record solid returns on a 12 month view and while there is considerable anectodal research to support this opinion, our leading indicators certainly boost our confidence that better times and increased equity returns lie ahead.
Barry Lindsay is the chief investment officer and Darryl Briggs is the investment strategist at National Mutual Funds Management NZ Ltd
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