Personal finance and investing columnist at the NZ Herald

Brent Sheather: Low-value takeovers a turn-off for shares


New Zealanders invest too heavily in residential property and not enough in shares, according to the experts, and in evidence Brian Gaynor has shown in this newspaper that the value of our stock market per New Zealander is low relative to the same measure for Australia.

There are a multitude of reasons why local investors eschew the stock market as a savings medium but the recent attempted takeover of New Zealand Farming Systems Uruguay (NZS) by Olam perhaps flags a few of them, some obvious, some not so obvious.

When one company makes a takeover bid for another company the company being taken over must produce a target company statement (TCS).

The most important component of the TCS is the independent adviser's report (IAR), whereby the target company commissions an independent adviser to prepare a report to help shareholders make a judgment as to whether they should accept the takeover or not.

However, if the IAR for NZS is any indication of the typical IAR, many retail investors are probably not a whole lot better informed after reading them.

In fact the NZS IAR really didn't provide the sort of information that mum or dad could use to make a decision, unless the reader had a degree in finance. Most retail investors don't have a finance degree and even if they did the nuances of the independent adviser's report might have escaped them.

The issue in front of NZS shareholders was as follows: NZS had bought a portfolio of dairy farms in Uruguay via a public float at $1 per share which was shortly followed by a 1:2 cash issue at $1.50 per share to give an average cost for shareholders who bought at the IPO and took up the issue of $1.17 per share.

The Olam offer was 70c per NZS share and the IAR report concluded they should take the money, thereby serving up a 40 per cent loss.

So there is one obvious reason to fear the stock market - investing in individual shares can turn out badly. But it should be noted that we can get around this risk easily by diversifying our share portfolio widely.

Mum and Dad NZS shareholders might reasonably, upon receiving the takeover offer, wonder to themselves, as anyone buying or selling a farm, house or commercial building is normally wont to do, "What are the farms valued at?"

This salient point perhaps didn't get stressed as highly as it might have warranted in the IAR and, at 81c, it was almost 16 per cent higher than Olam's offer. Furthermore, on June 1 NZS advised the stock exchange that it had sold one of its farms at a price 23 per cent above the valuation used in the IAR.

So instead of highlighting the worth of the farms in the traditional manner, as might be achieved via a sale, the IAR instead focused readers' attention on the valuation as determined by a standard but complex valuation methodology known as discounted cashflow analysis (DCF).

On the basis of the investment adviser's assumptions in the DCF, the IAR gave the Olam bid the go ahead.

But for the sake of all those retail NZS shareholders without a finance degree, we should put under the microscope arguably the most critical assumption in the DCF and discern what it means.

That key assumption is, of course, the choice of discount rate: in determining the value of NZS the adviser decided a 12 per cent discount rate was appropriate.

There have been whole books written on the determination of discount rates yet there was minimal mention of how the adviser got to 12 per cent or what 12 per cent actually means.

The TCS ran to 72 pages yet the discussion of the discount rate amounted to about a quarter of a page. Perhaps the investment adviser's most substantive statement was "selection of the appropriate discount rate ... is fundamentally a matter of judgment".

The other important piece of information about the discount rate alluded to its significance when it said that a 0.5 per cent reduction in the discount rate increased the value of the NZS shares by 6c or 8.6 per cent.

So in view of these facts let's take a close look at the mysterious world of discount rates. First up, it is not necessary to know the mechanics of how discount rates work, but it is important to know what they mean.

Wikipedia defines the discount rate as "the rate of return that can be earned on an investment". So here is a possible revelation for NZS shareholders who accepted the takeover offer: at 70c the expected return on NZS shares is a whopping 12 per cent a year.

That sounds pretty good compared to the 2.9 per cent a year available from 10-year US government bonds and especially good when compared to the 6 per cent a year that the authors of the Global Investment Returns Yearbook reckon the world stock market will return for the next 100 years.

Of course, an investment in NZS is probably more risky than buying the world stock market or US bonds yielding 2.9 per cent, although some people would argue that the very nature of these low prospective returns makes bonds and the world stock market especially risky.

In any event, 12 per cent is a pretty attractive return, so it's not surprising that Olam is keen on the deal. If we, for example, thought a 10 per cent return was appropriate for NZS and changed the discount rate accordingly, that would value NZS at 94c.

Mike Staunton, a professor at the London Business School and co-author of the Global Investment Returns Yearbook, has taken a look at NZS and calculates that the discounted cash flow analysis uses an horizon of 18.4 years and thus a future value of $5.63.

The wonders of compound interest are certainly impressive when the interest rate is 12 per cent. I wonder if the data was presented this way in the target company statement whether shareholders would have been so keen to sell to Olam.

But concerns don't finish here. A recent article in London's Financial Times citing a report by the Bank of England talks about a possible disconnect between the rates of return as implied by the stock and bond markets and the discount rates being used by companies to determine whether capital investment or acquisitions get the go-ahead or not.

Specifically research has shown that "the discount rates applied to future cash flows were much higher than either equity holders' average rate of return or the return on debt". Is that the case here and if so has it been the case in other takeovers?

Either way, whether 12 per cent is appropriate or not, a target company statement needs to properly inform retail shareholders - and probably a few institutional investors, as well - as to exactly what a 12 per cent discount rate means.

Retail investors are more familiar with price earnings ratios and dividend yields so it would have been more informative to set out what multiple of profits and dividend yield - assuming, for example, a 50 per cent payout ratio - NZS would be on at full production at the price of 70c.

Presumably this data is in the NZS five-year business plan financial model, which the Olam directors on the NZS Board will have seen but, significantly, was not made available to other NZS shareholders.

That doesn't sound fair and might be something that the Financial Markets Authority might look at, especially if it is wanting to ensure an even playing field.

So here is perhaps another reason for the low capitalisation of our stock market - New Zealanders may be accepting takeovers at lower prices than their companies are worth.

The independent adviser market in New Zealand seems to be dominated by a firm called Grant Samuel, which prepared the NZS IAR.

Grant Samuel refused to divulge what proportion of the independent adviser reports that it had undertaken in the past three years valued the target company at or below the level of the takeover offer.

* Brent Sheather is an Auckland-based authorised financial adviser and his adviser/disclosure statement is available on request and free of charge. He and clients of Private Asset Management own shares in NZ Farming Systems Uruguay.

- NZ Herald

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Personal finance and investing columnist at the NZ Herald

Brent Sheather is an Authorised Financial Adviser and personal finance and investments writer

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