Brian Gaynor:  Cloudy skies don't point to downpour

The New Zealand sharemarket has had a good run in recent years but there are no similarities with the boom-and-bust conditions of the 1980s.

This conclusion can be reached from an assessment of the NZSX-40 Capital Index, which was established in January 1957 with a base of 100 and is the only long-term measurement of the NZX.

This index, which doesn't take dividends into account, stood at just 603.36 on September 18, 1982, and soared to a record high of 3968.89 exactly five years later.

As Table 1 shows, in the five years to September 18, 1987, the market rose a phenomenal 557.8 per cent, with the lowest annual return being 30.1 per cent in the last 12 months of the bull market.

By comparison, the past five years have been fairly modest. The NZSX-40 Capital rose just 17.1 per cent and 15.2 per cent in 2003 and 2004 respectively, and a mere 19 per cent in the five years to December 31.

At the end of last year, the NZSX-40 was still 33.9 per cent below its September 1987 peak.

The NZX argues that a capital index does not fully reflect the performance of our sharemarket because it excludes dividends and we have much higher dividend yields than other countries. As a consequence, the exchange has managed to convince market participants to accept its NZSX-50 Gross Index as the benchmark index.

The new index was established on February 28, 2003, with a base of 1880.85, the same level as the NZSX-40 Capital Index on that day. The gross index overstates the performance of the market because it is calculated on the basis that all dividends - cash plus the attached imputation credits - are reinvested.

This is unrealistic and, in its recent Fonz prospectus, the NZX warned investors that their actual return would be less than the performance of Fonz's benchmark index, the NZSX-50 Portfolio Index (Gross), because imputation credits were not available for reinvestment.

Even though the NZSX-50 has been inflated by the reinvestment of non-cash dividends (imputation credits), it was still 22.8 per cent below the September 1987 high at the end of last year.

There are several reasons why the old NZSX-40 Capital Index is much more likely to head up towards 3000 than back to 2000 over the next few years. These factors include the stable business environment and our high dividend yields.

Table 2 contains a list of the 30 largest listed companies at the end of 1984. The only one to remain a listed New Zealand company with exactly the same name is number 30, Steel & Tube Holdings. The other 29 have either been taken over, restructured, broken up, merged, gone offshore or have been delisted, restructured and relisted again.

The list demonstrates that there has been a huge attrition rate in the New Zealand corporate sector during the past two decades, mainly due to economic reforms and the pernicious influence of the large number of highly geared investment companies in the 1980s.

At one time or another, Brierley Investments had large stakes in 10 top 30 companies; NZI, Carter Holt, Winstone, Progressive Enterprises, Cable Price Downer, Newman and Dominion Breweries. There is a role for the likes of Brierley, Chase, Judge, Rainbow and Equiticorp but we had far too many of them and their influence on the corporate sector was extremely negative.

In the 1984 top 10, Fletcher Challenge has been broken up; Brierley and Goodman have emigrated; Carter Holt acquired NZ Forest Products and Alex Harvey; and ANZ, NZI and Wattie fell to foreign buyers. Fisher & Paykel, which has been divided into Appliances and Healthcare, is the only top 10 company that is still listed and in a better shape today than 20 years ago.

Of the top 30 companies in December 1984 only three: Carter Holt, Fisher & Paykel and Steel & Tube, have remained listed New Zealand companies. By comparison 20 of the 30 companies included in the Dow Jones Industrial Average in 1984 remain listed and in a fairly similar structure. This represents a 67 per cent survival rate compared with only 10 per cent in New Zealand.

There should be considerable long-term benefits from a dramatic and sustained restructuring period. New Zealand's listed companies have gone through this process yet some commentators believe that our market is overvalued even though it is still more than 30 per cent below its 1987 peak on the old benchmark capital index.

If the market is overpriced what was the point of the pain and suffering during the late 1980s and throughout most of the 1990s?

The more optimistic view is that the corporate environment will be far more stable over the next 20 years and this will allow well-managed companies to adopt successful long-term strategies. Fletcher Building and the two Fisher & Paykel companies are good examples of organisations that have adopted a long-term view that should be successful in a stable environment.

Another feature of our sharemarket is its relatively high dividends, particularly compared with more developed markets.

Just before the 1987 crash, the market's historic dividend yield was 2.6 per cent compared with a yield of 15.6 per cent on 10-year Government bonds. The average gross dividend yield is now about 6.5 per cent and 6 per cent on 10-year Government bonds.

The sharemarket was hopelessly overvalued in 1987 but the present dividend payouts are far more sustainable because balance sheets are stronger, operating cashflow more secure and the operating cash/dividend ratio is higher.

As dividend yields are expected to fall into line with other sharemarkets over the medium to longer term, mainly due to the influence of the New Zealand Superannuation Fund, the outlook for the sharemarket is positive as long as overall economic conditions do not deteriorate sharply.

As far as 2005 is concerned, the market outlook is reasonably good due to a combination of factors including relatively high dividend yields and a stable corporate environment. In addition, the prospects of a minor Government spend-up in an election year should help underpin economic activity and company profitability.

It is unlikely that the NZX will match its 2004 performance but a capital return of between 5 and 10 per cent, plus an additional 6.5 per cent from dividends, is a realistic target.

That is a better proposition than putting your money in the bank.

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