As the dust settles from another NZ corporate reporting season, Harbour Asset Management director, Shane Solly, finds a clear warning for benchmark-huggers in the data
There were more misses in the latest New Zealand listed company reporting season (for the December period) than beats against market expectations.
This has contributed to earnings forecasts being cut, with earning growth expectations sitting around 4-5 per cent for the next few years. There is risk to earnings forecasts from slower revenue and higher costs, particularly for cyclical companies that depend on a strong economic tailwind. In this environment investors may need to be more selective about where they invest their capital.
Equity markets are fully-priced – something Harbour has been highlighting over the last year. But full valuation is often not the trigger for poor returns.
As with other global markets the NZ equity market performance has been driven by the performance of a small number of companies (such as a2 Milk, Vista, Synlait, F&P Healthcare, Meridian and Genesis).
The compositional change in the NZ equity market over the last 10 years, with electricity generator/retailers that tend to have high Price-to-Earnings multiples now making up a large portion of the market, makes historical comparisons difficult.
Until the NZ market composition changes with the listing of new large NZ businesses (such as a bank) overall NZ valuations may look elevated versus history but may just actually be at a full level based on industry mix in the market.
Growth and yield stocks have been the best performers – growth because structural change (such as technology) is benefiting the winners over the losers, and yield reflecting the significant fall in interest rates (both in short- and long-term bond yields) over the last 20 years. Value stocks have lagged. While optically cheap versus historical valuation multiples, cyclical and value stocks remain at risk of earnings disappointments from a cyclical slowdown in economic activity and structural change that challenges their long-term business positioning.
Risks to overall market performance would include the US Federal Reserve restricting monetary stimulus (unlikely in the near term), long term interest rates increasing as economic activity improves from recent lows as economic stimulus (particularly from Chinese authorities) kicks in (unlikely in the near term), and a protracted China-US trade negotiation weighing on confidence.
Closer to home, the Australian Federal election may see a further step down in confidence levels.
And locally the introduction of both a CGT and increased bank capital adequacy ratios by the Reserve Bank of New Zealand (RBNZ) may increase uncertainty and produce a weak period of NZ economic activity. Labour costs may continue to increase faster than revenue growth. This would be a tough environment for NZ companies that depend on the NZ economy to perform in.
Harbour believes it’s time to be increasingly selective about where to invest.
December quarter performance variance between active NZ equity funds was wide, in many cases reflecting the degree that funds’ investment weightings matched the weightings of the NZ equity benchmark.
By holding close to index weight investments, some ‘active’ NZ equity funds produced reasonable returns relative to the benchmark in the December quarter, boosted by the strong performance of electricity generation/retailing sector. But the NZ equity market may be losing some of its lustre with earnings slowing and changing liquidity flows.
The NZ market has been supported by de-equitisation. De-equitisation refers to when the reduction in size of the listed equity market due to privatisations of companies (via takeovers, mergers and acquisitions) and returns of equity capital (including share buybacks or special dividends) exceeds new equity issuance by existing and new listed companies.
While there is potential for ongoing merger and acquisition activity to shrink the NZ market, the potential for banks to list their NZ businesses following tougher RBNZ bank capital adequacy requirements may turn the tide in favour of net new equity issuance. The recent sell-downs of large blocks of Spark and Contact by offshore investors suggests that NZ valuations may have peaked relative to similar relatively high earnings certainty investments in other markets.
Harbour’s equity growth funds continue to favour selective shares in growth companies such as a2 Milk, Mainfreight, Summerset, Vista and Xero that can grow through the cycle due to structural change rather than being dependent upon cyclical economic activity.
Shane Solly is Harbour Asset Management director and portfolio manager