Thinking about finance companies
Wednesday, September 21st 2005, 9:15AM 
2 Comments
One of the hot topics of the moment is finance companies - and how bad they are supposed to be. But let's get one thing straight here - not all finance companies are bad.
We are currently researching a story on fixed interest investing and it's good to get other views of what is happening in the market. Our goal is to provide something that is informative and balanced.
You could quite easily though, get the impression that finance companies and their secured debenture products are not a safe place to put your (or your clients') money. Such a myth is perpetuated by the likes of the ASB Bank and its recent survey.
The problem I have with the ASB research is that it looks like sour grapes. It's a competitor having a crack at another competitor.
I say this as the bank was happy to make sweeping statements but refused to provide examples to back up its position. (Maybe as publishers we should have handled the story differently?)
It is important not to generalise about any sectors and it is worth re-reading this piece from Broadlands Finance along those lines.
James Lockie at Cairns Lockie put out an interesting note the other day, and you have to agree with some of his comments.
For instance finance companies have become popular because other investments haven't delivered in recent years.
They offer guaranteed returns. If an investor deposits funds with a finance company for two years at 9.85%, that is the return they will receive.
He is quote critical of fund managers and their inability, or lack of desire, to offer some form of guaranteed return.
I do note that Money Managers' owned Orange Finance went some way down this track recently.
Lockie also raises the issue of "transparency of fees".
He argues that there are "absolutely no fees paid by those who invest in finance company debentures". Fund managers seem to have a plethora of fees that are often hard to rationalise.
One must remember though that finance companies aren't offering these investments out of the goodness of their hearts - as some advertising has shown some make fantastic profits.
Lockie also puts forward consistency of returns as a plus, saying "finance company returns have performed well, despite many changes in the economy."
The challenge though is how to pick the good from the bad. I have some thoughts on some of the research, or so-called research, out there, and will write on that soon.
Hopefully the piece we are putting together on fixed interest will also help you understand the sector.
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I can't let this go unchallenged, especially the comments by Mr. Lockie. A few brief points:
1. Finance company debentures are NOT guaranteed - show me one finance co. that uses this word anywhere. The loans are 'secured', in many cases against fast depreciating assets such as cars, fridges, LCD TVs and the like, and in some cases potentially appreciating property developments. I don't know what planet you're on if you think that this equates to a guarantee. Why on earth would a company offering a guaranteed return need to pay 4% more than the NZ Govt bond to raise money??
2. Debentures may appear to have no fees, but in reality mums and dads are lending their money to finance companies for 8% to 9.5%, and the finance co. is then lending this money out at anything between 12% to 30%+. The 'invisible' fees are very significant. How else is the MD of one finance company (much sold by financial advisers) able to pay himself a salary of A$1.5m a year - far more than the salary paid to the Chief Execs of most large listed companies??
3. "Other investments haven't delivered". I presume this means unhedged international equity managed funds, into which many financial advisers piled their clients at the peak of the tech boom in 1999? Anyone investing in NZ and/or Australian direct shares would have done very nicely indeed in the last 5 years.
4. Some finance companies have performed well in a very favourable economy. But where are those profits going? Certainly not to the mums and dads provide the finance companies with their funding. Let's see what happens in a downturn. You only need one large finance company to fail, and mums and dads (and not a few financial advisers) will suddenly realise that these things are anything but low risk, and stop investing.
It amazes me that there are industry 'experts' who clearly have no idea that there is NEVER any such thing as a free lunch in investment, and 9.85% p.a. returns cannot be 'guaranteed' or risk free.
Perhaps some of these people also think that a Standard & Poor's B+ credit rating is good?? According to S&P, a NZ/Australian company with a B+ credit rating has about a 23% chance of defaulting over a 7 year period.
Like any investment, there is a place for debentures in portfolios. Unfortunately, I think you'll find that there are thousands of mums and dads out there with 100% of their portfolios in debentures, many of them thinking they are invested in safe, secure, guaranteed deposits, when the reality is that the opposite is the case.
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Finance companies are like school teachers, truck drivers, lawyers, journalists, painters, doctors, and financial advisers.
33% are very good, 33% are competent, 33% should go and do something else.
Politicians, real estate agents and car dealers are the exception. Probably 10% are OK and 90% are rubbish.