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Bruce Sheppard - Stirring the Pot

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Bruce Sheppard - Stirring the Pot

Postby Share Investor » 21 Apr 2009 09:19


I am going to post selected Bruce Sheppard columns here. He is quite often right on the money, very controversial and honest to the point of appearing rude. Awful but I like him kinda stuff.
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The upcoming corporate debt default

Postby Share Investor » 21 Apr 2009 09:27

While on the face of it most of our listed companies have moderate debt levels, especially in a normal market place, the world today is far from normal. I am part way though an analysis of all of our top companies plus all of those listed companies with significant debt and over half of them may well find that they are, or will shortly be, in default of their banking covenants.

Companies do not disclose their banking covenants, but must disclose when they are in default under the continuous disclosure rules. Nuplex provided an interesting case study on a number of issues. Particularly on the attitudes of boards to the timeliness of disclosure, in Nuplex's case some time after they technically defaulted, but the NZX investigation will flush that out. And if guilty Nuplex will be fined, adding to the company's woes. Any fine should be paid by the directors not the company for such transgressions. The second interesting disclosure was the nature of the banking covenants themselves.

NuplexSo this will be the beginning of a series of blogs, that examines the issues of banking, how banks function, banking covenants and how they are policed, banks attitudes to default, and the fundamental weaknesses of our banking systems due to its reliance on foreign capital and further the fact that most of the commercial banking in NZ is conducted by companies not owned in NZ.

Let's start first with how banks function at a macro level.

See the full story at Brucie's Blog or click on the attachment below
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The sharemarket, what is it anyway?

Postby Share Investor » 13 May 2009 22:42

Each day when we open our paper or the internet each listed business is given a score; it is called the share price.

If the company gets a bad score (a low price) it is assumed that it has that score for a good reason, and if it has a high score likewise. When companies get a high score the boards and management feel proud and mention their rising share price in annual reports as if in some way they can share some glory from this score card.

Boards are just human, they respond to the daily ritual of being marked by a market. I too am human, Connexionz a small public company in which I owned shares and am on the board. It had its score market down recently from 15c to 10c. I didn't feel to good about that.

But once I reflected on it, it actually means very little other than a shareholder, for their own reasons, was forced to meet the market. And as such the score was not a personal reflection on my, the board or the company's performance. Many board members, however, do regard the share market score card as a reflection on themselves, and sometimes it is.

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The numbers, how bad?

Postby Share Investor » 15 May 2009 08:32

Having gone through the accounts of 47 listed companies with a banker's mindset, I will go through a few observations about these companies before I give you the numbers.

I'll do this in terms of presentation of financial statements and also highlight a couple of issues that have arisen out of these reviews.

Then I will explain to you the numbers and how I have compiled them. Finally I will tell you what I plan to do with the seven who look to be in default, two of which are well known, being Nuplex and Fisher & Paykel Appliances and the 10 others that look awfully close to default on 2008 numbers.

On second thoughts, I will start with what I plan to do .For obvious reasons it is not appropriate to name the companies individually as until the companies have had an opportunity to comment that would be inappropriate. As the Shareholders Association writes to companies on a regular basis, it is more appropriate that the Shareholders Association conducts its usual process on bringing such matters to companies' attention.

Normally the Shareholders Association publishes such correspondence on its website, after 7 days. But as the issues are so fundamental and the presumption of insolvency so damaging, this would be inappropriate also. This said if companies fail to reply at all after follow up, publish we will.

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A response to NZX

Postby Share Investor » 15 May 2009 12:05

Bruce responds below to CEO Mark Weldon over the statement NZX issued (click here to read NZX's statement and the Dominion Post's story based on it) in the wake of concerns first raised in Bruce's BusinessDay blog about the financial health of some listed companies.


I have thought about this long and hard, read all my blogs. They explain the background to the issue, and they explain the simple matrixes that I have applied and they have explained how I have analyzed the financial statements with this in mind. Either analysts are blind stupid or inefficient, the simple numbers that you need to check reasonable compliance are these and they don't require a detailed breakout of financial statements:

They are these:

1) How much interest are they paying, a bit hard to find sometimes but not hours of work.

2) Continuing EBITDA (earnings before interest, tax, depreciation and amortisation), not hard to find either but you do have to make some assumptions about what is recurring and what is not, this is explained in my blog.

3) Interest bearing debt, and where it is parked, parent subsidiary, its composition between capital notes, and those notes' terms, bank debt and so on. Currency risk is an exposure, and hedging polices come into play. I have not analyzed hedging as disclosure on this is such a tangled web of crap that it is almost impossible to work out how they have hedged their interest and debt exposures and the issues that go with that. Many have foreign currency debts with no natural hedge.

4) Book Equity... that is easy.

5) Net tangible assets is a bit harder but not to hard.

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F&P, strategic assets and foreign investment

Postby Share Investor » 29 May 2009 08:20

10:53 28/05/2009

That idiot Michael Cullen (with Clayton Cosgrove and David Parker's help) vetoed the purchase of a dominant stake in Auckland International Airport on the basis that the asset was strategic. The Canadians were to buy 40 odd percent of the company and our local bodies, also stupid in their handling of the offer, would hold around 15 between them.

Of course, despite what the Canadians said we all knew control would pass, but wrapped up in their offer were governance provisions to protect Auckland airport as a New Zealand company.

Prior to Fisher & Paykel Appliances' announcement yesterday the Shareholders Association wrote to them urging them to proceed with a rights issue to all shareholders rather than a share placement. This is our standard position on all capital raising as we believe a fundamental right of shareholders is the right to own, meaning the right to put up cash if they want to before anyone else gets the chance. Sometimes this is impractical as the shareholders have lost heart or have no funds and placements are the only way for a certain outcome.

The placement of a 20% stake with Chinese interests is on the face of it alarming.

The negative factors in the placement are in my view as follows...

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Bruce Sheppard's Stirring The Pot: Picking a Share

Postby Share Investor » 30 Jan 2011 22:31


Bruce Sheppard's Stirring The Pot: Picking a Share

Any investment is worth to you what it will return to you over its expected life. As you outlay cash to purchase such an investment, "return" to you means cash returns.

As most investments can expect to keep returning cash to you until they fail, and good ones don't fail, the income from such investments can eventually be regarded as an annuity.

Humans on the other hand expire, and thus every investment has a time horizon on it, not dictated by the investment, but dictated by the investor's own circumstances.

Thus every assessment of an investment's future cash back to you should include a notional sale at a point in the future that is tailored to your own investment horizon. For most this should not be less than five years or more than 10. This does not necessarily mean you sell the investment at any time during that period.

So in order to value an investment and determine if it is cheap, you have to assess the likely future cash flows of the business. So how do you do this?

Brokers and forecasts

If you are penny wise and using an online broker, consider changing to a full service broker. If you are a full service broker's client, you should receive the bi-annual research data that they produce which will include one, three and five year comprehensive forecasts for cash earnings and dividends for most of the large companies and some of the small ones too. In addition, if you are thinking of buying a share, if they have any research on it they will send it to you.

Now while the cash flows they produce are interesting, and I have had these for over 20 years now, beyond one year they are totally conjecture. There is no statistically significant correlation between forecasts of earnings and actual outcomes beyond at most two years. So the most you should look at is the one year forecast.

This forecast is generally prepared by the broker following a detailed review of the financials, and a discussion with management, and the board. The forecasts are thus in essence the management and board's forecasts, and the most you can expect from continuous disclosure is a poor shadow of this data.

Historical Data

Well at least this is fact rather than conjecture, or is it?

Profit or EPS is simply an opinion. Earnings are now so spun with Financial Reporting standards that it is difficult to rely on Earnings or Earnings per share either. This said the past is a better source of data than the conjecture about the future.

Even the cash flow statement can be gamed, interest received from borrowers for example, was it really received by the lending finance companies.

What you can believe however is two things only. The price you have to pay for the share - as that is the money you outlay, and the cash that has been paid back to shareholders as dividends over time. Dividends are real cash. Or are they? Sure some companies hoodwinked shareholders with dividends that they pay with borrowings, in which case such dividends are not sustainable into the future, but testing the sustainability of past returns is phase two after you have completed the first shift of opportunities to reduce the list.

The first pre-screen

With listed equities (private company investing requires a different approach) to determine what I want to look at in more detail, I have a simple ratio called the PEGY ratio. This is an extension of the James Slater PEG ratio which I found in his book the Zulu Principle.

The plus of this ratio is that it does not require you to do much work or for that matter to make any assumptions. It is simply a hard number assessment of the value of a particular share.

The ratio, and even me a mathophobe can do it:

PE/( G+Y).

PE = the published price earnings ratio.

G = Normalised EPS growth over 5 years turned into a percentage multiplied by 100.

Y = the current pre tax dividend per share divided by the current price multiplied by 100.

PE and Y you can get from your morning paper, G, requires you to do a bit of work, ie you have to go back over five years of financial statements and pick out five years of Normalised EPS and calculate the growth over five years and turn that into an effective compounding growth rate from year one to year five. So I only tend to do this for companies that actually do have a dividend yield, as the lower the dividend yield the higher the growth has to be to justify the investment and with NZ equities growth is hard to find.

The lower the result of this formula on the face of it the cheaper the investment is, and thus on the face of it, it might be a buying opportunity; the higher the ratio is, the less attractive an investment is.

For example - you can buy a company on a PE of 20 with a Yield of 5 percent and a growth rate of 5 percent, this has a score of two. Or you can buy a company on a PE of 12 with a yield of 10 percent and a growth rate of 5 percent, this is a score of .8. Which company would you prefer to buy?

Cautionary note

Now before you get carried away, the PE ratio and the Yield quoted in the paper is not always right. Sometimes you will see really low PE ratios and this is sometimes because they have used the reported profits, and not the normalised profits. So check it. Likewise sometimes they get confused about Imputation credits as well, and these are valuable.

Any score more than 1 is unlikely to be cheap and anything less than .5 may be a bargain.

This first skim is about the return side that you can expect from an investment, now the harder work begins, understand the risk.

In no particular order:

The risk of total failure.

The risk of adverse surprises to earnings or dividends.

The sustainability of dividends going forward.

The risk of fraud idleness or stupidity, i.e. the people.

So now to the second skim:

The first thing to look for is debt. In big companies debt is not like it is for us mortals, ie about security, it is about cash flow. So the key ratios for you to check around this are as follows:

Net interest bearing debt ( net of cash holdings)/ Earnings before interest tax and depreciation. ( EBITDA)

It will be a rare company that can sustain a score above 5 and a ratio of around 2.5 is, depending on income volatility likely to be safe enough. As soon as it goes over 3 you are taking a risk of total default at worst and income or return default at best.

Earnings before interest and tax/ Interest paid. ( interest cover)

$4 should be the minimum you would consider safe.

Debt/total tangible assets.

This is sometimes important, but if any of the other ratios look too risky is a good one to do as well. If the lending is less than 50 percent of tangible assets even if the income is currently crappy or if the margin is a bit thin to cope with an adverse event the tangible asset backing might hold off a total default.

The list should be smaller now.

The third skim is around the risk of dividend default.

Three key things.

The first is the dividend cover ratio which is the net profit after tax/ dividend ( net of ICA or other tax credits , but excluding Resident withholding tax).

A ratio of 2:1 is normally pretty safe, a ratio of $1.20 to $1 will normally indicate a high risk of dividend volatility especially if debt is also high.

The next is earnings volatility. This is the maximum adverse movement EPS in the last five years.

It is earnings that fund dividends, high volatility of earnings and low dividend cover would indicate that there is a high risk that dividends will be volatile and might drop before they revert to trend.

And the final one which should always be checked is the operating cash flow to dividend cover ratio. This is operating cash flow / Dividends net of ICA taxes etc.

It is cash that pays dividends , and if it looks a bit tight but everything else looks ok, you should be alright for at least one year.

Now in terms of your filtering you need to set your own filters, but mine go like this:

A PEGY ratio of more than .9 strike it off the list.

Debt, more than three times EBITDA, or exceeding 80 percent of NTA cross it out.

Earnings per share volatility greater than 30 percent, this is the biggest one year adverse fall in earnings in the last five years strike it off the list.

The sum of five years' operating cash flows should be greater than 70 percent of reported profits, and should be at least $1.50 for each dollar of dividends paid over the last five years, if not strike it off the list.

With these filters the list will be a short list, and now the real work begins.

Assuming you have nothing on your list and you are still keen to invest move the parameters by 10 percent. If more than one on your list, then rank them from the lowest PEGY ratio, as that is the most cheap stock relative to risk levels you are prepared to bear.

Now you are going to do some work on the company.

What do they do, how do they do it, why would a customer buy their product or service, how do they sell it what is the selling process, how do they reward the team to make money, who are the leading managers , who are the directors who are the major shareholders what are their track records?

To start with get the last three years annual reports, start with the oldest, read the Chairman's and CEO's reports. Write down the key predictions and outlooks, map it to outcomes. Check what they have said they will be doing , strategically, see if they did it. You are looking for people who take risks, who have at least some reliability of forecasting and say what they will do and do what they say. The most recent report has to have some element of optimism about it, and there should be no adverse continuous disclosure announcements.

Now before you buy you need to assess the likely return you will make on this investment, ignoring gearing. The factors are these dividend, earnings and growth of each over a timeline.

How much is enough of a return to justify the risks you have accepted is mute point and one that investors in finance junk ignored.

My base line is 8 percent for any equity, being double the tax paid risk free rate of return from cash, very roughly. I then increase this by the amount of volatility, so 25 percent volatility increases the hurdle rate to 10 percent. I then increase it if debt is high, again I calculate a base line figure. Let's assume the target has debt 15 percent higher than base case, or earnings are not correlated with cash, again if out of line, by how much as a percentage, or if the cash or profit cover of dividends is skinny again by how much. Then I add these percentages together, say the sum of these is 80 percent, then increase the base line yield by 80 percent. The required yield on this investment is 18 percent. If on a far wind the prospective yield is more than this, then the share is worth buying, if with the rubbish factor taken in for the first year, it is still above the base line equity yield it is still worth buying. Other wise pass for the moment and set yourself a target price. If you have to wait six months, learn patience, but before you put in the buy order make sure nothing has changed.

In the words of Buffet, the market rewards the patient at the expense of the impatient.
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Bruce Sheppard's Stirring The Pot: Investing & Concentration

Postby Share Investor » 30 Jan 2011 22:39


Bruce Sheppard's Stirring The Pot: Investing & Concentration

The antithesis of portfolio theory, (which is like opium - it allows you to drift off into a fog induced trace in an investment sense) is the concept of concentration.

In the words of Lord Maynard Keynes, "Concentrate your risk concentrate your mind".

Debt is the ultimate risk concentrator, thus when you are young the use of debt will ensure that you approach investing with considerable concentration. This means you are living your life awake and alert. This level of concentration will ensure your mistakes are more colourful and you will remember the lessons to be learned, and the rewards will also be more pronounced.

Debt - which is also pressure - will teach you to think. It will raise your adrenalin and its use early on will be like a grindstone to your knife-edge intelligence and intuition. Thus you should approach the use of debt with measured caution.

As you get older the adrenalin rushes are no longer necessary in an education sense, and in fact may be bad for your financial and physical health. However, debt is still useful as you get older to ensure effective scale of investing activity as well as ensuring liquidity.

All investing requires work, or cost - or both. With property, understanding the maintenance that has been deferred, council restrictions, title issues, perhaps also soil and land stability issues, should ensure you spend a lot of time on a property acquisition. Thus any investment has to have enough scale to justify the effort.

With property however sometimes you have to do all of that work on a number of properties. You then bid at the auction and lose out to someone else either on emotion, ie they just loved it, or because the saw something you didn't .The costs of acquiring one property are often the costs of thoroughly looking at 10. If the property is only $100k then the cost is very high relative to the investment. Debt allows you to achieve economies on the cost of acquisition.

With equities you also have to do work, however if it is a listed equity all shares are the same and have the same risk, so you do not have to worry about missing out. This means the costs of investing in equity are your costs of researching the companies you buy as well as the cost of looking at the companies you don't want to buy.

To buy $5k of shares should require the same amount of work as buying $100k or $1m. When you buy a private company you will normally get an option and a detailed due diligence before you part with money, But the costs are also high.

With equities you have to understand the business, its resources and obligations, its market position, its competition, which the people are who are running it and who the owners are just to begin with. Of course if you are only investing $5k you might find that the time-related costs of doing this work are out of all proportion to your means.

But if you have done the work and found yourself a winner, access to debt allows you to achieve economies of cost.

With equities, unlike property, as result of doing comparative value work on say 10 reasonably good companies you might find three that you would be happy to buy. Then you can spread your investment across all of the top companies that you have found. The counter to this is Keynes. If you had to pick one and only one, you will really sweat which one it is to be when you have that choice. "Concentrate your mind."

Or in the words of Jim Slater from the Zulu Principle, If you have done the work and you are in a position to write yourself a list, of good companies, why would you take one dollar off the best one on the list an invest it in the worst one on the list?

There are a couple of presumptions behind his comment. The first is the presumption that you have done the work, and the second is that you have all the information. Now while the world is considerably better than it was when he wrote his book (we have continuous disclosure for example), YOU WILL NEVER KNOW EVERYTHING.

Debt-based investment strategies are a relatively safe one way street to riches in a bull market that is perpetually rising, eg housing, In a flat market debt is ok as well if it is an income trade-off - It will suddenly focus you on the investment's fundamentals. In a generally falling market debt is only ok if you considerably expand the amount of work that you do around the income of the investment. If you fail to grasp this, your knife will be consumed by the grindstone.

Here's one example of the use of debt. A friend was thinking of using his entire $1m credit line. He was proposing to fully borrow it, and lock it in for five years at say 6 percent. He lent the lot to Fonterra at 8 percent pocketing $20,000 pa for in his words, "free". At the end of five years he hopefully gets repaid, and it will work out fine. In the meantime he is out of the market, and he has forgotten the reason he had the credit line in the first place, to be able to respond to superior opportunity.

Using debt for property is fairly well understood. However, low yields means other income is required to support such a strategy. That's only rational in a perpetually rising property market. We all have our views on that.

With property, and negative gearing the ability to survive is predicated on separate independent income. In a recession unemployment rises, bonuses and pay increases evaporate, and sometimes that independent income to pay for your negative gearing route to property wealth disappears. Remember to harvest a capital gain you have to be in the market over time. Too much debt and you will lose control of how long you are allowed to be in the market.

Virtually no one thinks abut using debt to buy equities, and they should.

The plus of equities is immediate liquidity if you need to or want to close out, this is much harder with property. Last month only 15 dairy farms settled in all of NZ. The lowest since records began. It is a bit telling on the state of the economy that our banking system can even deal with financing our main export earner.

Valuing equities is an art not a science but some simple things can work well if discipline is applied to sort out the crap.

If you could (and you can) buy a share for $2.40 with earnings of 20c per share after tax in the last full year, and if it also paid out 15c gross in dividends, preferably fully imputed, and the EPS had been growing on average over the last five years at 10 percent pa, and the dividend payout at 15 percent pa over that period , you would have an ok investment.

If it could replicate that performance over the next five years, your ungeared returns would be 19 percent pa tax paid, assuming the share was saleable at the same PE ratio at the end of the fifth year as you bought it at on day one. If you borrowed all the money at 7.75 percent you would be investing the difference between dividends and interest in the first year and you would have to wait a year for your tax refund. (Thus you are still making an investment in a traditional sense, as you are parting with some hard money up front.) With 100 percent gearing on purchase price you move your tax paid IRR to 81 percent.

Equities can be volatile. It's useful to look at the level of EPS volatility on the downside over the last five years. If say, this company had had an adverse movement of 25 percent at some time in the last five years and you have adjusted your forecasts to assume that immediately after you bought it this would occur again and that then it would revert to the historical growth pattern, without gearing your return over five years would still be nine percent. With gearing it drops to four percent. But if the adverse event is 30 percent you still make seven percent without gearing - with gearing you go into loss. An adverse event of 50 percent loss of income and dividends would have to occur before you would lose money over five years without debt.

This underlines the increasing sensitivities that debt has on return and risk, and it is this exceptional brilliance that will focus you when considering investing in equities.

The next and last but one blog, will be about sifting the investments worth considering from those that are not.

Read Bruce's disclosure here.
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Bruce Sheppard's Stirring The Pot: Investing in managed fund

Postby Share Investor » 30 Jan 2011 22:42


Bruce Sheppard's Stirring The Pot: Investing in managed funds


The simplest way to think about managed funds is as equities and a business in their own right. They pool capital and manage it for profit.

It is a business for the manager, they receive fees and these businesses are quite valuable, so by default what they do with your funds is also a business.

The business of a fund manager is selecting promising business either based on their judgment or as part of a planned process for investing in businesses. Some managed funds choose to run a business of speculating on markets, or commodities or whatever, and plan their business acquisition strategy and disposals around movements in the market.

Forget all this crap, just use the skills you need to buy a business to determine if you would buy a unit in a managed fund.

The offer document for a managed fund will be fairly limited compared to that of a company raising equity, and the reporting will also be pretty limited. That said, the complexity of activity of managed funds is also fairly limited.

Mostly these funds will have an investment plan, they will be buying property, bonds, mid-cap equities, top 10 equities, international equities. They will be allowed to deploy debt or they won't be. They will have a manager who has a fee structure and this is the essence of the business of a managed fund.

If you believe the story and the people look smart and trustworthy, and if it looks like there is no moral hazard obvious in the structure, then you can consider buying a managed fund just like you can consider buying an equity so long as it is cheap relative to its performance. Valuations of equities are another article, but suffice to say it is rare that such funds are cheap.

The plus of managed funds is that you don't have to think about the underlying prospects of real businesses, all you have to think about is whether the strategy that this particular fund has for investing in businesses makes sense to you, and whether over time it appears to have worked. On this basis look at what the likely future passive income will be, and whether this promise of returns is competitive compared to other opportunities for return.

The plus of managed funds is that you pool funds, or perhaps even have the option of drip feeding in small amounts over time, so that you spread your risk over many businesses. This said you can do this with equities if you execute your investment plan rationally, but it is much harder to do this with property. Note also that small investments have a higher fee cost relative to the sum invested than bigger investments.

With equities each buy or sell has a transaction fee of $7, this is charged on $1m or $1000. With managed funds it is the same, but worse, the costs of small investments can be up to 8 percent on entry. This said this will be disclosed so you can do it with your eyes open.

One of the negatives of managed funds is that you ultimately trade off liquidity, and you are putting another layer of people between you and the customer's wallet. Remember the more people between you and the customer's wallet, the higher the costs and the greater the chance of human error, fraud or inefficiency.

There are many types of managed funds I will cover as many as I can think of, but understand this, I have never invested in a managed fund ever. I have some clients who do, despite me trying to talk them out of it. Some are happy with the perceived security - most are disappointed with the performance.

The first question to ask is this: is the fund a closed fund or an open fund? A closed fund is one that is seeking a fixed amount of capital, and will then usually list on an exchange but will not offer redemptions. The liquidity of these is predicated on the willingness of new investors to buy old investors out in the market. There are very few closed funds in NZ, and mostly these are run privately and off market by private equity syndicates.

For example one broker firm runs closed private equity funds for people to pool money to invest in private companies. I have not invested in these either, however one client who did and has done so for many years has done very well. These funds are closed and usually fixed term, never less than five years.

You cannot get your money out early and you have to be a habitual investor to participate, meaning more than $2m of assets or more than $200k annual income or you have to be investing $500k in the individual offer. The presumption of Securities law is if you have $500k to throw around you don't need protection.

Until the FIF regime came in there were a number of closed funds operating out of the UK which could be bought on NZX. The FIF regime drove them out of our market but they can still be bought. If you buy these you may (there are thresholds) pay tax on 5 percent of the open market value whether they pay you any thing or not.

Open funds are funds that take money in directly and all the time. The have a unit buy price and a unit sell price. The buy price is the price you pay to buy a unit and sell price is the price at which they will redeem a unit if you want your money back.

The units are revalued each week (usually) to reflect the underlying value of the assets in the fund, an entry fee is added to arrive at the buy price and an exit fee is deducted to arrive at the redemption price. Have a look in the newspaper at fund manager returns over five years and also look at the buy-sell spread as an approximation of entry and exit fees. Sometimes you also have to pay fees as well.

In a market that is moving upwards gradually and perpetually, the plus of these funds is guaranteed liquidity and a guarantee that you will receive the fair value of the asset you have invested in less the exit fee. With closed funds they behave like shares - sometimes they are cheap and a seller does not get the underlying value of the assets.

Open funds however have an inbuilt liquidity hazard on a falling market. When the markets fall, the unit values drop, then they have the unit holders asking for their money back.

It is a bit like finance companies with short maturity debenture stock on issue; when the confidence goes you end up with a run on funds which naturally accelerates.

The fund managers thus has to hold cash to deal with redemptions, so this builds in a level of inefficiency into open funds, and when the cash runs out they have to sell down their investments in a falling market thus accelerating the fall in the general markets. Sometimes they have to do really hot deals off market.

What this means is that those who stay in the fund are punished by liquidity, and eventually the fund manager has to suspend redemptions. At this point there is zero liquidity. Open funds are very dangerous in falling markets, and more dangerous than owning equities directly.

Funds are further categorised on what they do, and generally they fall into two categories, with many sub sets. The first are passive or index funds and the second are active funds.

Index or passive funds are mostly buy-and-hold equities or whatever to mirror one or other index. Some do this same task by using derivates, i.e. futures contracts on the indexes themselves. They rebalance periodically to deal with the ups and downs of the market so that they get close but not exactly aligned with the movements of an index.

Mary Holm actively promoted Index funds before she got KiwiSaver to play with. Index funds are fine in a rising market but in a falling market, the tide is guaranteed to go out on your portfolio.

If you choose to play with buying and selling index funds, you need to try and second guess markets and economic outlook in general and if you think this is easier than understanding a businesses prospects , you are dreaming.

The big patterns around human activity for the next 15 to 30 years are generally negative particularly in developed economies, Index funds are thus a road to poverty in my view. The plus of index or passive funds is low fees, the manager just has to apply the formula and stick to the plan, he doesn't have to think.

Active funds actually try to out guess the market, some are market traders, some are growth investors, some value investors, and the pitch to you is that they can do this better than you, and thus deliver a superior returns. Ok that is a business, and can be judged as a business, and its units can be bought or sold on normal valuation principles. This said if they are an open fund they then attract more money , and the more money they attract the less active they become. In the words of Jim Slater, "Elephants don't gallop"

Managed funds do however have a number on inbuilt moral hazards and there are virtually none that do not have one or all of these moral hazards built into their structure. These moral hazards if the funds are listed usually mean that the fund trades at a discount to asset backing. Eg the property funds, and always will until the management contracts are terminated. All managed funds have a less than transparent governance structure.

Now to the inherit moral hazard.

In equities the payment for services also creates a moral hazard but it is different in managed funds. With equities, due to better functioning boards, and the nature of the contractual relationship with management this hazard can be dealt with more effectively. With managed funds the nature of the contract creates an enduring and very valuable asset for managers, and board processes and contractual arrangements devised on set up make it impossible to regulate reward or even manage the team.

Most managed funds have a fee structure for the mangers based on funds under management. Some in addition also have success fees on top. The rational for the fee based on assets is that it is intended to cover the real costs of investment and provide a wage for the management team or a return to the owners of a management company. Success fees on top are designed to share success, defining success also sometimes creates a mismatch between unit holders and managers. However this is the same for equities, if rewards are misaligned with owners' expectations.

Some managers of these funds are exclusively rewarded by a fee based on assets. The alternative is a flat fee structure, which of course doesn't accommodate growth in the funds and thus the required amount of work, and for small funds means that the fee cost to assets is too high. In many respects closed funds are better, as they take in a sum of money, work out how much it will cost to run the money they have got and draw a fee equal to cost, perhaps expressed as a percentage of assets. This means that as the asset value grows the manager derives more fees - there is nothing wrong with that, the asset value has grown.

With property unit trusts the fee structure often also includes an ability to obtain cost reimbursements or commissions or fees upon the leasing or acquisition of properties.

There is no perfect reward system for managers and all create a moral hazard due to a mismatch between managers and owners expectations particularly over short and long term objectives. The role of boards is to balance this out. In many ways it is the most important task they have, but the one that often gets the least attention. In managed funds the board structure itself is flawed, more on this later.

The most common reward structure for base fees is the percentage of assets method. When combined with open rather than closed funds this creates a food chain that works against the interests of unit holders.

On day one there is one unit holder who owns $1000 of capital and pays the manager $25 in fees. The fund makes $200 during its first year after fees and the unit holder is happy. He has received nothing, as profits are reinvested. The fund's value is now $1200. The fund now attracts fresh capital of $1000 on the back of this success so the fund now has a total of $2200 and the mangers fee in the second year is $55.

In the second year the fund makes another $200 not such a good return so the manager who has the power to borrow raises debt of $1500, the fund commences the third year has $3700 under management and the fees have grown to $92.50. The business of the fund manger is valued at say three years income, so in the first year the fund managers business is valued at $75, by the end of the second year it is valued at $277.50. The fund itself has produced $400 of value spread across $2000 of capital and the mangers have derived fees in cash of $80 over the same time frame plus a market value asset of $277.50 has been created.

Thus the first moral hazard is created, which is the drive to attract the most money as possible and grow the total or gross value of the fund. This said, the managers are realistic. They know this only occurs if they can attract money from the market and retain the money they have got, thus they focus on how to increase the unit holders' disclosed value, as the better they perform the more money investors will give them.

As the amounts involved are significant, as shown above, and out of all proportion to the economic performance of the funds, the incentive on gross assets creates a natural desire to maximise debt. This increases the return to the manager, maybe to the unit holder too, but the unit holder carries most if not all of the risk. The next issue is the incentive to fraud, or window dressing results. You have seen the Huljich KiwiSaver fund issue. If you can pump cash into the fund and call it income, the consequences in fund attraction are out of all proportion to the cost of a few dollars of cash to bolster results.

The other thing that can happen is market manipulation. Say you hold a share that can be bought on market for a $1, and another fund holds a share likewise with a price of $2.

The fund manager thinks that share one is worth $2 and share two is worth $3, but they cannot reflect this in their books. If they can do an off market trade with each other, they can increase their profits by $1 each, which results in attracting more funds and adds $1 each to their asset base, which means they can increase their fees.

Off market transactions, funnily enough, occur most often at the end of a reporting period, but to cover their tracks they conduct activity on market to build up to or down to the price they want to trade at and the big sale happens off market. Now not all these transactions are motivated for the fee building nature that is the consequence but it is an obvious moral hazard.

Cost recovery fees. Without good governance and checks and balances these too can be manipulated. For example if the manager gets a fees on releasing property in the fund, the incentive is to have short leases and high churn, not good for asset values however. If managers are paid on acquisitions this is an incentive to look at an awful lot of stuff that you don't buy.

The remuneration moral hazard in managed funds is considerably higher than in direct equity investing.

One final point on remuneration. Managed funds normally sign long term contracts with managers. These are written before you ever put a dime in. Normally they are structured to protect the manager who is also the promoter when he issues the prospectus asking for your money, and terminating these is nigh on impossible without having the fund write out big cheques. There has been plenty about this in the paper recently too, with much wailing and teeth gnashing from investors. But frankly they were dopey buying the fund in the first place. The evil in this case was the financial planner who also had an interest in the fund manager. As I have said before the more people between you and the wallet the more chance for a skim.

Now to the governance of these funds. There is the fund itself, which is usually a unit trust. It will thus have trustees appointed for the unit holders these however are nothing more than custodians, and may if you are lucky, be given some powers to ensure that the manager operates the fund in accordance with whatever they have said they will do. These trustees are the same people who looked after your money in the finance companies. They cannot be easily removed by unit holders, and even if they are removed their powers are defined in the trust deed which was written before the fund went to the public to ask for money, by guess who, the promoters who are usually the managers. The managers pay them as well.

The board of directors of these funds are not a board that you get to appoint or remove as unit holders. Trusts do not have boards. It is a board of the management company appointed by - you guessed it - the managers.

So the only meaningful thing you can do in a governance sense is vote the manager out. Remember they wrote the management contract so if you do this they normally get a parachute. But before you can do that you have to call a meeting. That is sooner said than done and even if you do get one called to remove the trustee or the manager it would require a 75 percent resolution. The governance of most managed funds and particularly those structured as trusts, is completely ineffective.

So excessive moral hazard, expanded liquidity risk, and poor governance is the additional risk you take on board to achieve a spread of asset ownership. If you really must invest through managed funds pick ones that:

* are closed rather than open.

* are structured so that you get to appoint as owners of the FUND, the directors.

* the management contract does not have an excessive parachute.

* the management contract can be cancelled by the board on notice and does not require a meeting of unit holders.

* the management contract is for a fixed base fee, not a percentage of assets.

* The manager's performances incentive is based on income and or real asset growth not bought asset growth.

* the board has a sound track record and no baggage.

* incentives are used to purchase units in the fund.

* the manger has invested a significant amount of his own money in the fund.

Good luck with that.

And guess what team? Successive dopey governments have created the PIE regime and KiwiSaver which is the largest transfer of wealth to the private sector funds managers ever in NZ. All KiwiSaver accounts are parked in funds that have all these problems, and the sooner they bring on self managed funds the better. I am not a KiwiSaver and will not be until I am entitled to manage my own wealth.

Next blog is borrowing for investing.

Read Bruce's disclosure here.
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Bruce Sheppard - Stirring the Pot: Investing in Property

Postby Share Investor » 17 Nov 2011 06:13


Bruce Sheppard's Stirring The Pot: Investing in property

Another significant route for investing in businesses is the business of investing in property.

For the avoidance of doubt, all property investing is investing in businesses. Some of these businesses are owner-operated businesses, and others simply are a portfolio of investments in businesses. A commercial property owner with a number of properties is no different to an investor with a portfolio of shares; all that is different is the route to the business risk, and a trade-off of possible returns for different returns and different risks.

When buying a property, focus on the income. It is the income that will give you passive cash flow, or service debt. Do not consider capital gains. If you have income you have choice, to hold or not. Without income, your choice of holding is more difficult and impossible if you also have debt. You can, and should, consider the potential for income growth.

Let's start with a general property overview. It is a static, fixed investment with poor liquidity, incapable of partial liquidation (other than through debt). For the moment debt is readily available secured against property and thus economically it is the means by which partial liquidity is achieved. The cost however is the forfeiture of income. Rather than thinking of debt as a means of financing, think about it in terms of liquidity. When appraising an investment, any investment, look at ungeared returns first. It is the returns before interest expense that determine an asset's value. Gearing is just the means by which you finance an acquisition or improve your liquidity. Debt is not an investment. Debt is just negative cash.

Property never moves. The bit of land will be where it is today forever (unless it becomes coastal, or disappears into the sea, due to global warming).

While land doesn't move over time its economic use might change - or worse it might become economically useless. Farmland into desert for example. This said, you don't need to worry too much about these environmental forces, as in terms of your life cycle, Mother Earth evolves very slowly. What you do have to worry about is human activity.

Property is only worth something if there is human activity to support demand and thus value. History is littered with property boom and busts, the gold rush created towns (and valuable real estate) these are no more. Other resource booms likewise, forestry towns around Northland are an example. Now mere shadows of their former glory.

Last century between the end of the WW1 and the early 1930s Shanghai was a boom town, real estate went mad. By the end of the 1920s it was the 5th biggest town in the world. It had trade, manufacturing, commerce, let me see what is that? Business. By the end of the 1930s it was no more. Now 80 years later it is booming again. Why? Business.

The point is this: people, money and activity move. Property doesn't. In many ways this expands the risk of all property investing, as business is as fluid, or more fluid, than people . Money and activity move, property doesn't.

In Auckland - and I am sure every other major town in NZ - there are examples of dynamic population change. Twenty five 6years ago Glenfield was the industrial hub of the North Shore. Rents and property demand were hot. Then Mairangi bay was opened up and Glenfield slowed down. All the businesses wanted to be in Constellation Drive and rents fell. Now Albany is opening up. The difference this time is the land mass available is much bigger, so its demise is probably a long way off. However its short term demise is excess supply. Roads change. Once upon a time Avondale was a western town of note. New Lynn developed, a North Western Motorway was pushed through and Avondale became a pass-through back water. Human activity is dynamic, business reflects human activity, and property is static.

You may argue that residential property is immune to this as demand is constant, humans always need shelter. Ok but they need shelter where they want to live and this is driven by where they work and opportunity. Let me see, what is that driven by? Business. Take Tokoroa as an example. When the paper mill scaled back the town's biggest business became WINZ, and the intelligent moved out.

In short if you are a property investor you have to understand human activity, human emotions and demographics in addition to understanding business.

To do property well is harder than doing shares well. In terms of the short term (I mean a 20 year property cycle) you need to understands the psychology of the masses.

Where is everyone going? Why do they want to be there? Is this driven by all sorts of things, infrastructure, parks, roads, quality of life issues, work (business activity)? These change continuously so you have to read the local and international press, you need to understand local and central government.

Sovereign risk is considerably higher with property than with business. Business can evolve, property can't up sticks and move country.

Now let's look at differing types of property, residential first.

Residential is most likely the lowest risk but don't fool yourself into thinking it is independent of business. In essence your business risk is the portfolio of businesses that supply the work to the people who want to live in your house. You however do have an independent income stream in that you receive a payment for the use for your property from a worker who lives in it. Good workers always have work, and will always pay their rent. You on the other hand are operating an owner-operated business. Your business is the provision of long term accommodation.

Residential is generally the most liquid of all property investments, on the basis that there is a base need, but again go look at Tokoroa. So in risk terms, residential property has a wide spread of underlying risk to income. The exposure is the sum of all activity in your locality, and is more liquid than any other properly investment, but less liquid than listed equities. Because of this high liquidity you can borrow more on residential property than you can on commercial, generally.

The return on residential property varies widely. In Auckland it can be as low as 1 percent and as high as 11 percent, (this is income after expenses but before interest). The reason for the variation is not to do with the big issues of macro economics, but to do with the quality of the improvements and the perception of the locality.

Higher returns are paid to compensate for the lower quality tenants attracted to certain properties. A bit of advice on residential property - your return is enhanced if the property is full all the time, with people who pay and who like where they live and don't move about too much. Damage, downtime, non payment and churn kill residential property. Thus the more expensive lower face value cash return, actually present better over all value, mostly.

This sort of properties looks like this in terms of cash flow (in Auckland). Rent $24,000, rates insurance and maintenance $5000, passing income $19,000. At current interest rates, which is the risk-free rate of return on investment, a purchase price of more than $500,000 is nuts. In fact as the risk-free rate of return is rising and rents will remain static, if anything you should pay less. A property with this dynamic in Auckland would still cost you $600,000 plus. So why buy it? It is over priced. (Disclosure: I have a number of these properties, which have always been expensive and I should really sell but won't. Why? Because they are close to a number of business areas and public transport and I have in 25 years never had any difficulty collecting rent, and the rental income fully pays all my bills. I am thus irrational. And this irrationality explains markets; markets are a trade in the irrational).

Now to commercial property.

Commercial is an investment at first instance in the business that operates from your premises. If the business is not viable the rent will not be paid. If you have to evict the tenant, then the residual risk is the same as residential, will the demand dynamics turn up another business that is prepared to pay to trade in your locality?

With commercial property it is feast or famine, You have income or none, and the re-letting time is considerably longer. Thus the cash flow, while more certain when tenanted, (as the tenant generally pays the outgoings) is more risky. Thus banks lend less on these properties and they show considerable interest in the tenants. This should be a clue to what you should show an interest in.

Some commercial is special purpose construction. You can't use a Pizza Hut for much other than a Pizza Hut without spending money. A power station or a steel mill is even worse. Thus with commercial buildings it is wise to see as many possible configurations for a business use as possible when you buy and as many value extension options as possible.

The dynamics of office space, industrial and retail are also different. Malls have made it hard for strip retail, apart from chinese junk shops and cafes. These turn over perpetually, but a bit like residential there is always another retailer dreaming of a fortune. With strip retail - which is all you can reasonably buy directly - it is all about foot trafficand the durability of the destination. In Auckland this really only means Newmarket and maybe Takapuna. Some of the smaller suburban hubs command local support e.g. Devonport. But to buy into these trendy areas the returns on capital cost are less, but more defendable. Buying Hunters corner or Birkdale is more hard work as a landlord.

Industrial is also hard, the bigger the unit the safer then tenant, (this means 5000sq m plus). Small units tend to have two dynamics: the tenant outgrows you and moves out, or worse goes broke. Commercial is also hard. Office space is stratified by various grades , if you go to the heritage building grade the yields can look ok, but with a lot of aggravation.

Again the commercial hubs in NZ are really only Wellington CBD, due to the size of government, and Auckland and to a lesser extent Christchurch. But for the average punter buying a $40m building is a bit of a stretch so you really only have the choice of buying part of it, either by syndication, co ownership titles or though buying a floor, with all the crap of body corporates, or perish the thought a listed property fund, and then you are back to shares.

This is not intended as a detailed description of property and its risk, or of how you add value to property, it was simply intended to stimulate your thinking about what property is, and some of the risks that are not often conceptualised.

Read Bruce's disclosure statement.

Next blog: managed funds.
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