Spicers' Quarterly Strategy Paper

This quarter, we focus on the following key themes:

• The improvement in the standards of corporate governance in New Zealand
• The deteriorating attractiveness of global bond investments
• The state of the business capital expenditure cycle

Over the past decade, there has been considerable debate about the reasons for the poor performance of the New Zealand equity market. Explanations have ranged from its small size and high concentration through to the value-destroying international acquisitions of some New Zealand companies. One area that has been a concern to both small investors and large institutions alike is the overall standard of corporate governance. An example of poor corporate governance would be when management make decisions in the interests of just one major shareholder instead of all shareholders. Or when management pursue expansion plans when the firm’s capital could be deployed more profitably elsewhere or returned to investors.

In the past, these sorts of examples have been all too prevalent in the New Zealand market. However, as institutional shareholders Arcus have detected a noticeable improvement in the conduct of corporate management in New Zealand in more recent times. This improvement is evidenced by a trend toward linking executive compensation to improvements in shareholder value and greater fiscal discipline in decisions regarding growth projects.

Arcus suspect that some of these improvements are due to a greater awareness of the potential for shareholder backlash in highly visible forums such as annual general meetings. This has reinforced the important role of institutional activism in protecting the interests of clients. There is the potential for better performance from the New Zealand equity market if this trend toward more responsible corporate behaviour continues and investor confidence grows.

Global bonds less attractive for investors

During the third quarter of 2002, investors allocated billions of dollars to the corporate and government fixed interest sector. The key effect of these flows was to take the yields on 10 year US Treasuries to their lowest levels seen in 50 years. Two key forces can explain such behaviour. Firstly, the desire for perceived “safe haven” assets, and secondly, the pursuit of past returns. Arcus contend that with low bond yields neither of these are sound reasons to make large allocations to bonds.

There is a risk that investors flocking to the bond market may find themselves unfortunately positioned in the next market to undergo a correction. Currently, many international bond yields are well below any measure of long-run equilibrium. These concerns do not extend to the New Zealand bond market where yields are generally closer to normal levels. New Zealand interest rates have been unusually stable over the past 20 months, in contrast to overseas where central banks have been lowering rates aggressively. It may be some time before the wide spread between New Zealand and international bond yields begins to contract, but investors should be cautious about expected further falls in international yields.

State of the business capital expenditure cycle

Globally, business capital expenditure has been very slow for the last two years. These low investment levels are a direct result of over-investment inside many industries through much of the late 1990s. Having over-invested, many companies have since been delaying capital spending programmes, preferring instead to make do with existing assets.

But with household spending having maintained reasonable momentum throughout this period, the sales line for many companies has remained respectable and very strong free cash flow generation has been the result of these harder attitudes towards capital expenditure.

Strong cash flows and the improved balance sheet strength that results will ultimately support a recovery in business spending. This will reduce the dependence on consumer spending, which has been the mainstay of economic activity through much of this period.

SECTOR OUTLOOK

Clearly the international equity market has been exceedingly volatile. The net effect of this has been a significant shift in investor behaviour away from equities and towards bonds. This means that, while bond yields have fallen, the earnings yields on equities have risen. As the daily volatility of the equity market subsides there are enormous amounts of uninvested cash waiting to be redeployed into shares.

The strategy of our investment teams remains broadly unchanged. Our international managers are using their research resources to find companies whose future earnings stream can be purchased cheaply today. After a period of indiscriminate selling by the general market, these attractively priced companies are more readily available.

US equities - At current market prices, many stocks are quite attractive relative to cash and bonds. Our managers are positioned for a modest recovery in US economic growth, as interest rates remain supportive for both consumers and corporates. While estimates of US economic growth have been reduced, a double-dip recession remains a low probability.

Non-US equities – Despite the sluggishness of European economies, falls in long-term interest rates are making valuations very attractive, while a stronger euro should add to the relative attractiveness of European equities. The outlook for Japanese equities turned more positive after bank reform began to look more likely. Whether this current momentum for reform will carry through into action however, or instead slowly dissipate into the inertia that has characterised Japanese policymaking over the past decade, remains to be seen.

Australasian equities – In general, corporate balance sheets have conservative levels of debt and are well positioned to weather any further slump in the global economy. Local economies have benefited from ongoing consumer expenditure (supported by strong residential property prices) and sympathetic monetary policies. Nonetheless, our manager’s concerns about the banking sector have not diminished. Our investment manager has substantially increased our allocation to New Zealand stocks as they believe there is greater earnings certainty here than in Australia.

Australasian property – Set against the macro economic outlook of a sluggish return to global growth and prevailing low bond yields, property values remain largely intact. Net inward migration is seen as being a key driver of the relative resilience of the domestic economy and underpinning demand in residential housing, notably in the major urban centres. This will, in turn, support growth in commercial property.

US fixed income – The US fixed income market is now providing its lowest yields in 50 years. Indications suggest that over time there will be upward pressure on bond yields as corporates borrow to invest in real assets at the same time as federal government issuance increases. While the US fixed income market has been one of the best performers this year, Arcus expect that fundamental factors will be detrimental to this sector and are reducing our exposure.

Non-US fixed income – Fixed income markets in Europe are not as unattractive as the US but still don’t represent good value for investors. House prices in the UK have defied gravity and the market has been displaying many speculative characteristics such as booming lending for investment properties. The Bank of England will be reluctant to add fuel to the housing market, so out-performance by the gilt market is unlikely. Yields on Japanese government bonds remain around 1% and are possibly one of the least attractive investment sectors available at this time.

Australasian fixed income - The yield spread between New Zealand and US 10 year bonds is now close to the highest levels in a decade. In isolation this suggests that local fixed income investment is fairly attractive, but investors need to consider the risk that inflation (which is already close to the top of the target range) rises further as the labour market tightens. Arcus believe that Australasian fixed income will be an attractive investment on weakness, when market pricing more fully reflects the inflation risks.

Currencies - Arcus expect that interest rate differentials with the US will continue to support the kiwi and recommend that investors maintain a hedge over a portion of their foreign currency exposure, if possible. Most other currencies have also gained against the US dollar (eg the euro, Australian dollar and Canadian dollar) and Arcus see less risk for investors with exposure to these currencies.

ARCUS' MARKET ASSESSMENT

Unless one has a particularly negative view of the world economy in the months and years ahead (and Arcus do not), it is difficult not to conclude that, in contrast to bonds, equity markets represent very good value for long-term investors at and around current levels.

Based on relatively conservative assumptions for both economic and earnings growth, the current equity market arithmetic is fairly compelling. Add together likely sustainable dividend yield levels and the dividend growth rate, hold operating earnings multiples steady at today’s levels of around 15-20 times and it is difficult not to forecast broad equity market returns in the high single to low double digit category. Include the potential for more selective stock selection strategies to identify pockets of additional value and the proposition for equity investors looks very attractive.

While supporting the case for equities, it needs to be acknowledged that we have been through a significant bear market in global equity markets that has left its mark on many investors. For some, attitudes toward equity market risk are likely to have permanently changed and in certain instances the likely impact on future income streams and other capital requirements may be material. Notwithstanding an attractive valuation backdrop, this suggests a measured approach to determining appropriate equity exposure is probably warranted. Conversely, when dealing with investors whose risk-taking capacity is still strong, a more aggressive stance to equity exposure may be appropriate.

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