Brian Gaynor 's Opinion

Investment columnist for the NZ Herald

Brian Gaynor: Xero - bubble or global giant?

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Software firm high-risk but with exciting potential and an aggressive and ambitious growth strategy

Xero's soaring share price has some market veterans and historians muttering the word Poseidon.

To most people Poseidon is the "Earth-Shaker" of Greek mythology who creates earthquakes when he strikes the ground with his trident. To sharemarket investors Poseidon NL (no liability) is the listed Australian nickel company that epitomised the 1969-70 ASX mining bubble.

Sceptics claim that Xero is another Poseidon, it will crash and burn just as the Australian nickel company did more than four decades ago. The optimists believe that Xero will be our first major global company and transform New Zealand just as Nokia changed Finland in the 1990s.

Only time will tell whether the sceptics or the optimists are correct.

There is a large amount of literature on financial bubbles but no conclusive agreement on their origins. Some economists believe they occur as a release from a long economic downturn while others believe the root cause is easy credit.

Robert Shiller defined a bubble as: "A period when investors are attracted to an investment irrationally because rising prices encourage them to expect, at some level of consciousness at least, more price increases."

Other studies associate financial bubbles with new developments, for example railway stocks in the mid-19th century, radio companies in the 1920s, internet shares in the 1990s, "cloud" and social media in recent years.

This new-developments theory fails to explain the numerous land and property bubbles.

The Poseidon bubble had its origin in the buoyant nickel market, with prices increasing from under £2000 a ton in 1968 to around £7000 a ton in late 1969. The commodity was in short supply because of the Vietnam War and major industrial problems at Inco, the large Canadian producer.

The appetite for mining stocks was heightened by the strong share price performances of a number of companies, particularly Endeavour Mining Corporation NL. The sleepy Tasmanian tin miner experienced a share price surge from under A$1 to A$10.60 in 1968.

In 1966 Poseidon was struggling to survive - with its shares trading at just two cents - but two years later it had enough money to hire a prospector who headed off in his caravan to the isolated Mount Windarra in Western Australia.

Poseidon shares traded at A80c in early September 1969 but on Friday, September 26 they surged A42c to A$1.90.

On Monday September 29 the company announced that it had discovered nickel at Windarra and its share price soared to A$5.60. On Wednesday October 1 the directors indicated that it was a major discovery and the share price closed at A$12.30.

Two days later the Australian Financial Review's front page headline was "Nickel boom turns radioactive" and Poseidon's shares finished the week at A$16 compared with the previous week close of A$1.90.

Poseidon's share price then took off, partly because it was the ideal speculative stock with just 2 million shares on issue.

It also carried a large number of other mining stocks with it as investors purchased any shares with nickel interests, particularly if they had a low dollar value.

On Thursday December 18, 1969, the day before its annual meeting, Poseidon shares closed at A$110 after reaching a high of A$121 earlier that day.

The Adelaide meeting was packed, with over 500 shareholders and a number of London brokers. By contrast, the company had failed to achieve a quorum at its 1968 annual meeting.

The main issue of contention was the placement of 500,000 shares between A$5 and A$6 each compared with a share price in excess of A$100. Directors argued that they had decided to make the placement in September when the price was below A$10.

The motion was carried and most of the new shares were placed with associates of the Poseidon directors.

The stock closed at A$130 after the annual meeting and by the end of 1969 it had smashed through the A$200 mark and finished the year at A$210 on frenzied trading activity in Australia and London.

In London The Economist ran a big bold headline "Australia; a Beaut of a Boom". The respected magazine noted that "Australia more than any other country is being carried along by Japan's explosive economic growth".

The market was buoyed in January 1970 by rumours that Tasminex NL had a promising nickel prospect in Western Australia. Its share price went from A$3.30 to A$18.50 on January 27 and hit A$75 the following day before closing at A$40.

Meanwhile, Poseidon was on its final run with its share price reaching an all time intraday high of A$280 on February 5, 1970. This was just over four months after the bubble began.

Its share price fell rapidly over the next few months, as did most of the other Australian mining stocks.

The Windarra mine commenced nickel production in 1974 but it was not a success because of low grades, high costs and low nickel prices. Poseidon was delisted in 1976, the mine was taken over by Western Mining and finally closed in 1991.

Endeavour Mining was suspended by the ASX in 1973 and Tasminex, which had a share price peak of A$90 during the boom, developed a small tungsten mine in Tasmania but de-listed in 1985.

There is no question that Poseidon was a massive bubble because it was characterised by market manipulation, insider trading, share churning back and forth between the same parties and optimistic company comments. Poseidon had no revenue and failed to take advantage of its high share price to raise new capital to develop the Windarra mine.

Nokia's share price also surged a quarter of a century later, from €0.65 in mid-1991 to over €60 in 1999. Finnish investors believed the stock was overvalued and sold out to overseas investors, mainly United States hedge funds.

The company had a golden period in terms of market penetration and profitability before the arrival of the smartphone but most Finnish investors missed out on the major share price rise because they sold out in the early and mid-1990s.

Xero's share price doesn't have the characteristics of a Poseidon type bubble but it is difficult to tell whether it is overvalued or not.

The company has a strong board, there is no insider trading or market manipulation and it is selling a service, signing up new customers and generating revenue.

More importantly it has raised additional capital above the existing share price and this will be used to grow the business.

Overseas institutions have invested in the business because they believe that the most important issue for Xero is to grow its subscriber base and it will be easier to do this after raising $180 million of additional capital.

If Xero's subscriber growth rate increases then shareholders will be happy, if it slows investors will be disappointed and the company's share price will fall.

There won't be much focus on the company's lack of profitability as long as subscriber growth rates are steady or increasing.

The name of the game as far as Xero is concerned is to add more and more customers and annoy its competitors. This was the strategy adopted by 42 Below which resulted in a successful takeover offer from a major international vodka company.

The best advice for New Zealand investors is to recognise that Xero is an extremely high-risk company, albeit with exciting potential and an aggressive and ambitious growth strategy.

We are not used to this determined approach just as Nokia's Finnish shareholders were reluctant to buy into the company's global ambitions in the early 1990s.

Investors should look at any shareholding in Xero from a portfolio perspective. It should not have a high weighting in portfolios and shareholders should be prepared to take profits as has founder and chief executive Rod Drury in recent years.

Brian Gaynor is an executive director of Milford Asset Management which holds Xero shares on behalf of clients.

- NZ Herald

Brian Gaynor

Investment columnist for the NZ Herald

Brian Gaynor has written a weekly investment column for the Weekend Herald since April 1997. He has a particular passion for the NZX and its regulation. He has experienced - and suffered through - the non-regulated period prior to the establishment of the Securities Commission in 1978 and the Commission’s weak stewardship until it was replaced by the FMA in 2011. He is also a Portfolio Manager at Milford Asset Management.

Read more by Brian Gaynor

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