Brian Gaynor: Good investment is an alien concept

There is a strong relationship between this week's two biggest business stories, the burgeoning current account deficit and the Feltex share price collapse.

They are linked by a number of factors, including the poor performance of our companies overseas, our willingness to sell assets to foreign investors at low prices and then buy them back at inflated values.

As table one indicates, the major contributor to the $10.3 billion March 2005 year current account deficit was the $9.4 billion investment deficit. Although the goods balance (the difference between exports and imports) has gone from positive to negative in recent years the investment deficit has accounted for at least 90 per cent of the total deficit in each of the past seven years.

The huge investment deficit is due to two factors: the large gap between New Zealand's offshore investments and foreign investments in this country (table two) and the poor performance of these assets, particularly when compared with high returns derived by overseas investors in this country.

New Zealand has overseas investments of only $89.8 billion compared with overseas investments in this country of $213 billion. This has resulted in a net investment deficit of $123.2 billion.

In the year to March 2005, we achieved a return of only 2.9 per cent on these assets compared with 5.8 per cent derived from overseas investments in New Zealand.

There is a big difference between the performance of outbound and inbound direct equity investments (the first line in table two).

Direct equity is where an investor owns 10 per cent or more of the voting power and has a voice in management. At the end of March, New Zealanders held $11.8 billion of offshore direct equity investments, which generated a 7 per cent return in the latest 12-month period.

By comparison, overseas investors held $49.4 billion of direct equity investments in this country and achieved an impressive 13.1 per cent return in the year to March 2005.

New Zealand is a particularly good place to invest as returns are relatively high. The latest Australian current account figures show that overseas direct equity investment in Australia achieved a return of 8.7 per cent in the year to March 2005, compared with the 13.1 per cent achieved in New Zealand.

When we sell a major company, particularly one with a high level of net earnings, it has a negative impact on the current account because the earnings are credited to the overseas owner on an annual basis (the purchase is a one-off item that goes through the capital account and does not appear in the current account).

The earnings of our four major trading banks, which are all overseas owned, account for about $2.1 billion of the current account deficit.

Based on figures contained in the recent KPMG Financial Institutions Performance Survey 2005, the earnings of the 15 overseas-owned registered banks in New Zealand contribute an estimated $2.6 billion or 25 per cent of the total current account deficit.

We have been hammered by the sale of ASB Bank and Bank of New Zealand to the Australians. First of all there has been a massive loss in shareholder wealth as these two banks are now worth an estimated $11.7 billion compared with their $2.3 billion sale price.

The combined net earnings of ASB and BNZ contribute about $0.8 billion to the current account deficit each year and this figure is expected to grow.

The other major items are portfolio investments, equity and debt, and borrowings.

According to Statistics New Zealand, the banks account for most of New Zealand's overseas non-equity liabilities of $149.9 billion. When one takes into account the estimated $2.6 billion of bank earnings attributable to offshore owners and the interest on their foreign borrowings, then these 15 financial institutions contribute over 50 per cent of the country's $10.3 billion current account deficit.

Feltex fits into the current account picture because it was sold in a distressed state to offshore investors, sold back at an inflated price and its performance in Australia has been poor, except for a short period.

Equiticorp's statutory manager sold the carpet manufacturer to BTR Nylex in 1990. In 1996, the private equity arm of Credit Suisse First Boston (CSFB) purchased the carpet manufacturer for $19.5 million.

In 2000, Feltex bought Shaw's Australian carpet operations and, last year, CSFB sold the group to the New Zealand public for $204 million, compared with its total investment of just $21.8 million.

The key issue as far as Feltex is concerned is its performance in Australia.

The group's Australian activities had after-tax losses of $6.6 million, $13.8 million and $3.3 million for the June years ended 2002, 2003 and 2004 respectively.

These losses had a negative impact on New Zealand's current account.

The IPO was launched shortly after the Australian activities produced a small profit of $5.2 million for the six months to December 2004.

The prospectus, which was dated May 5, 2004, was optimistic about Australia. It contained forecasts for the June 2004 year and projections for the June 2005 year (the difference between forecasts and projections will be important if the regulatory authorities or shareholders take the directors to court).

Directors were not anticipating any material change in general economic conditions or the Australian building or refurbishment markets in either the June 2004 or June 2005 years.

But there were already signs the Aussie housing market was easing before the prospectus was lodged.

Westpac's Outlook for Australian Property 2004-2006 dated March 4, 2004, predicted that housing approvals would fall from 163,000 in 2004 to 150,000 in 2005 and 140,000 in 2006. ANZ Bank's June Quarter 2004 Economic Outlook, dated April 8, 2004, concluded that housing demand had eased and dwelling approvals had fallen since mid-2003. It expected household consumption to fall and "housing associated purchases of complementary items such as furniture and appliances will also ease".

Most New Zealand institutions were sceptical about Feltex's prospects. They were reluctant to invest in the company because it had only one good six-month period across the Tasman and economists were warning of an impending downturn in housing demand.

The issue was aimed at individual investors who didn't have the expertise to assess market conditions in Australia. Feltex has always struggled to hold its $1.70 issue price. When it told the market on Monday that earnings would be about 50 per cent of the prospectus forecast, its share price was hammered.

The Feltex debacle is a major blow to investor confidence and is likely to encourage investors to sell shares in other firms to foreign bidders.

If these offers are successful, they will have a further negative impact on the current account deficit.

New Zealand is a virtual gold mine as far as private equity funds are concerned because we are prepared to sell assets at low prices and buy them back at inflated values.

How will we ever resolve our current account problems with this irrational approach to investing?

* Disclosure of interest: Brian Gaynor is an executive director of Milford Asset Management.